Carried Interest

2014-10-13

During the 113th Congress, and in prior Congresses, policy makers introduced legislation that would treat at least a portion of “carried interest” income as ordinary income for both income and employment tax purposes.

“Carried interest” is the share of net profits generated by a business, representing the contributions of “intellectual” and “sweat equity” of a partner to a business enterprise. The “carried interest” structure is a central feature of the process by which capital is raised and deployed in many segments of the American economy.

In the United States, for more than fifty years, the Internal Revenue Code (the Code) has permitted partners in investment partnerships to pool the capital of investors with the skills of entrepreneurs in joint profit-making enterprises.

To align interests and contributions to the partnership, the Code treats a partner’s “carried interest” in the profits on the same terms as the other partners.  This means that if the partnership’s profits are characterized as capital gains, then a partner’s “carried interest” would also be characterized as capital gains. Simply stated, partners in a partnership are treated similarly regardless of the form of their investment.

Hedge fund managers are investment management entrepreneurs that generally structure their businesses as a partnership and their “carried interest” is taxed at capital gain rates only if the partnership’s income is characterized as capital gains.

Notably, most hedge fund income is currently taxed at ordinary income rates, rather than at capital gain rates, because hedge funds generally invest in capital assets and hold them for less than one year, designating them as a short-term capital gain for tax purposes.

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