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Firms that sponsor private equity funds operate on a “two and 20” model. They typically collect a flat 2 percent management fee on all money committed to the investment fund by the limited partners. The management fees cover the costs of managing the fund and its investments, including payments to members of the private equity firm for work they perform.
Private equity firms argue that the 20 percent of a private equity fund’s profits that they earn are a return on the equity they have invested—the capital they have put at risk—and should, therefore, be treated as capital gains and taxed at the lower rate.
Typically, however, a private equity firm contributes $1 to $2 to the private equity fund for every $100 the limited partners have invested in the fund. Thus, 1 to 2 percent of the fund’s profits are a return on the private equity firm’s investment in the fund; the remaining 18 percent is a form of profit sharing by the private equity firms’ partners. As with other forms of performance-based pay, these earnings should be taxed as ordinary income and not at the 15 percent capital gains rate.
Eileen Appelbaum is a senior economist at the Center for Economic and Policy Research and the co-author of ‘Leaves That Pay: Employer and Worker Experiences With Paid Family Leave in California.’