carried interest: tax changes in prospect

what a carried interest is

The term “carried interest” is heard most often today in connection with the compensation of private equity and some hedge fund managers.  But it’s a more traditional term than that.  I first came across it about thirty years ago when I began to study the natural resources industries.

A carried interest in a business venture is an ownership (equity) interest where the holder participates in the revenues or profits of the venture, without having to contribute to paying any costs of it.  The holder is “carried” by other venture participants, in the sense that they pay what would otherwise be that party’s share of costs.   The metaphor is that the others bear the carried part’s burden.  Someone can be “carried” for a certain part of the venture or for all of it.

An example:  an exploration geologist acquires the right to drill for oil and gas on a highly interesting parcel of land.  He is either unable or unwilling to pay for drilling a well to find out whether there really are commercial amounts of energy down below.  Instead, he goes to a third party and trades, say, 2/3 of his rights in exchange for the other party paying the full cost of the initial exploratory well.  The geologist then has a 1/3 interest in the project and is being “carried” to an agreed-upon point in the exploration/development process.

In this example, the original geologist receives revenue from oil or gas production.  It is taxed as ordinary income, although oil and gas businesses do benefit from special tax breaks.

private equity refinements

Private equity-run businesses typically have very high degrees of financial leverage.  This has two effects on the enterprise:  the tax-deductibility of interest expense on debt lowers overall capital costs; and the debt magnifies the effect of changes in enterprise revenue on profits.

Also, private equity has pioneered the use of carried interest as a tax loophole for compensating high-ranking people in the private equity firm.  In simple terms, private equity uses customers’ money to buy companies, usually with a large proportion of debt, supervises their restructuring and hopes to sell them at a profit several years hence.   These individuals concerned have structured their management fee to be a “carried” percentage interest in the profits from the sale of their projects.

Although the money is, to me anyway, clearly an investment management fee (closely akin to deferred compensation bonuses) and although the private equity managers invest little or none of their own money in the project, governments around the world have until recently treated carried interest payments as long-term capital gains, not ordinary income.

Why is this distinction important?  –because in many countries, including the US, long-term capital gains qualify for preferential tax treatment.  In the US, for example, long-term capital gains are taxed at a 15% rate, vs. almost 40% for ordinary income.

changes underway

The House just passed a bill, which will go to the Senate next week, that changes this tax treatment, despite fierce lobbying from private equity and venture capital interests.  The bill redefines carried interest payments for tax purposes as 75% ordinary income, 25% capital gains.  A New York Times article from last Friday points out the academic research and the changes to the membership of the House Ways and Means Committee that have thwarted the lobbyists.

Similar legislation has died in the Senate before.  Let’s see what happens this time around.

my thoughts

I can’t think of another case anywhere in commerce where employees engaged in long-term projects, whether they be paid in increments through the life of a venture or in a lump sum at the end–or even in deferred compensation the may pay out several years hence, where their remuneration is considered a capital gain and not salary income.

You have to congratulate private equity for spotting and exploiting the legal loophole that has allowed professionals in this industry to earn outsized compensation.  But there’s no overwhelming evidence that private equity is so crucial to the national welfare that the loophole should stay open.  In fact, there’s some academic evidence that private equity provides no value, apart from what comes from the enormous financial leverage private equity applies to the firms they buy.

So I’m for the proposed change in the way the IRS looks at private equity carried interest.

You might argue that the $17 billion in taxes private equity would evade in the coming decade is just a drop in the bucket when compared with the national debt.  But you have to start somewhere.  Private equity should console itself with the thought that it has gotten away with paying much lower taxes than almost anyone else up until now.

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