Taxing Private Equity Carried Interest Using an Incentive Stock Option Analogy
Private equity funds are in the business of buying and selling companies. They make money when they sell their holdings at a profit. Fund managers are paid in part with a share of the fund's profits - a share called carried interest, or simply carry. It has long been the law that when profits flow through to the managers, the managers pay tax on the profits as if they had sold the stock or received the dividend for their own accounts. That is, if the fund recognizes long-term capital gains, the managers recognize long-term capital gains and pay a 15% tax.
Recent scholarship challenges this discrepancy, and legislative proposals seek to change it. Tax scholars, former policymakers, legislators, and even some business executives have argued that carried interest is, in substance, compensation for labor and should be taxed as such. They have accordingly called for tax law reforms that would, at least in some instances, raise the rate of tax that private equity partners pay on their carried interest. Opponents - principally private equity partners and those who represent them - argue that these reforms would create inequity, encourage investors to expatriate their capital, or otherwise harm the economy. The issue has even become a talking point for 2008 presidential hopefuls. No politically viable resolution of the issue has yet emerged, however. This Paper seeks to offer one - one that is both moderate and rooted in existing tax code paradigms.