Taxation of carried interest Discussion


Carried Interest

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Taxation of carried interest allows general partners of investment funds to share funds’ profits. However, congress considered taxing private equity fund managers’ carried interest at ordinary rates instead of the 15 percent rate that previously applied to this kind of income. The primary objective of taxing the carried interest is promoting neutrality between labor compensation of fund managers and other various types of labor income. However, there are issues raised because of carried interest taxation, which ought to be understood.

Viard (2008), in his article, outlines that the primary reason for taxing managers is because managers are being compensated for their labor. The carried interest is shared among fund managers. When the income comprises qualified dividends or long-term capital gains, there is a 15 percent tax rate imposed on the managers, applicable to this kind of income. Since the managers are being compensated for their work, they ought to be like other labor income rates instead of lower rates compared to dividends and capital gains. For that reason, Viard (2008) states that managers’ labor income, which also consists of the carried interest, should not be taxed at a lower marginal rate compared to other subordinate staff incomes such as the secretaries.

Equally, using carried interest instead of salary does not transform ordinary earnings into capital gains and dividends at the net level. However, it changes the allocation of both incomes. The use of carried interest results in managers receiving capital gains and dividends instead of ordinary income, which eventually lowers their tax liability. Nevertheless, this adversely affects the fund investors instead of the managers. Instead of taxing the salary payment of the managers, which would reduce their ordinary earnings, the fund investors experience reduced dividends and capital gains income, which reflect the distribution of a part of income allocated for the managers. If the fund investors are taxable, they suffer a tax increase, which offsets tax savings for managers. In cases of tax-exempted organizations, when the aggregate tax is deduced, the tax-exempted investors will have received no tax benefits. Through this instance, he outlines cases in which managers enjoy tax deferral and how fund investors can become tax-exempt.

Notably, Viard (2008) prompts the article’s primary question, which is whether the tax-reducing allocation should be allowed. Several aspects need to be considered, such as the extent to which managers can reallocate the income through means other than carried interest. That is considering the non-tax reasons prompted using carried interest and the extent to which, the extent to which the tax savings offset over taxation in other portions of the tax system. On the contrary, Viard (2008) argues that the manager’s initial award for carried interest during the establishment of a private equity fund is remaining untaxed. Prepayments for future labor services are equal to borrowing against future labor earnings, which is a valid reason for them not to be taxed.

One of the strengths moted in Viard’s (2008) article is outlining how investment funds are allocated and the tax rates. Viard (2008) adds that the income is divided among the fund’s partners since the investment funds us a partnership. The general partners and the managers receive an annual fixed fee equivalent to 2 percent of the invested capital as well as a carried interest that is relatively equivalent to 20 percent of the net income. He further adds that the carried interest designs vary among firms. For venture capital firms, the carried interest is normally a fifth of the income. For buyout companies, the rate of return on investment clears a hurdle rate of 8 percent prior to the managers receiving any carried interest, with the managers subsequently receiving 2 percent points of return and one fifth of the returns beyond 10 percent (Viard, 2008).

Viard (2008), in his article, he effectively outlines the internal revenue code, which provides that the maximum individual income tax rate for qualified dividends and gains on capital assets for a period of more than one year should be 15 percent. Other sections depict that the maxim rate for other ordinary incomes such as interests, short-term capital gains and wages are 35 percent. Another clause indicates that the preferential rate for dividends and gain income is applicable to individual alternative maximum tax. In cases of individual owned portfolio firms held for more than a year, their sale should generate. The distribution from these portfolios is a refereed to a C corporation, on which its income received a 15 percent rate if the managers and other persons directly own the firm (Viard, 2008).

Further, the article effectively describes how the carried interest the flexibility enjoyed by partnerships during the allocation of various categories of income and expense among partners. To determine these factors, they are noted in the partnership agreement. This articles strengths can be recognized in instances Viard (2008) adds the legislative proposals regarding taxation. For instance, the H.R 2834 bills applies that ordinary tax rates to income received by partners performing a significant amount of investment management services except to the extent that the earnings are attributable to the partners own capital investments. However, the bill was not acted upon and did not state the effective dates. Later, the house passed the H.R 3996, which had a similar provisions of revenue loss from a 2007 AMT and other tax exemptions, which was targeted to raise revenue by $25.6 billion. Notably, the democratic presidential candidate had also proposed to close the varied interest loophole (Viard, 2008).

However, Viards (2008) entirely raises negative claims against taxation of carried interest. Although the validity argues that the reallocation of carried interest affects the tax rules of the wide economy and that it allows managers to avoid tax restrictions, he does not outline benefits of the reallocation. The article illustrates the negative aspects of the reallocation but does not include the positive aspects to create a clear image of the reallocation of carried interest. The article does also not affirm whether it is completely clear that the reallocation is inappropriate.

Ultimately, I agree with Viard (2008) that the changing of taxation of carried interest is detrimental to the economy. It allows managers to defer taxation and tax restrictions. The article outlines various aspects of carried interest taxation and how managers become tax-exempt. It also illustrates reason why managers should not be taxed on carried interest as well as flexibilities that they enjoy. I also support Viards (2008) argument because the tax reallocation threatens to increase the growing income inequality by giving a tax break to the wealthiest individuals who comprise of fund investors. Although, I agree with the articles argument, it does clearly outline whether the reallocation with have detrimental effects to the United States Economy. The reallocation creates a loophole that allows owners or fund owners to monetize carried interest at very low tax rates. With such a loophole investor will save more than $30 billion in taxes for the next decade, which is a loss to the U.S economy (Herzig, 2009).



Herzig,D.J. (2009). Carried Interest: Can They Effectively Be Taxed.

Viard, A. (2008). The Taxation of Carried Interest: Understanding the Issues. National Tax Journal, 61(3), 445-460.


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