Not All Carried Interests Are Created Equa

Rosenzweig, Adam H. | January 1, 2009

Recently, a significant debate over the taxation of so-called “carried interest “in private equity funds has received much attention from scholars, the government, commentators, and the media. This debate has focused on whether private equity fund managers who earn a percentage of the returns generated by the fund should be entitled to preferential “capital gain” treatment on such returns. The primary concern in this debate revolves around whether managers are effectively being compensated for services normally taxed at higher rates while receiving the benefit of preferential rates reserved for capital gains. Proponents of reform point to the services being performed by the managers, while proponents of the current system point to the investment exposure to the underlying assets of the fund. In reality, however, both sides are partially correct: carried interest is “blended” in that it represents both a return to services and a return on capital. Since carried interest is blended in this manner, an analogy to either proves less than satisfying. The issue of blended labor/investment returns is not new to the tax laws, however. Historically, one way the law has attempted to address the issue was not by deconstructing such returns into constituent parts, but instead by imposing a “holding period” requirement. Under this approach, not all capital investments are created equal; rather, only capital investments held for an arbitrary period of time while bearing the risk of loss qualify for preferential rates. The current debate over the taxation of carried interest in private equity has failed to incorporate this element into the analysis, i.e., the role that holding period plays in denying preferential rates to blended labor/investment returns, such as carried interest. This Article will do so, concluding that, to the extent any reform of the taxation of carried interest within the existing framework of the income tax is appropriate, a better approach may be through the application of the holding period rules rather than through current proposals to either change the definition of capital gains or further complicate the partnership tax rules.