Why Carried Interest Shouldn't Be Taxed as Capital Gains

Yes, the cruelest month has begun, marked at its dead center by tax day. We have a Freakonomics Radio segment tonight on Marketplace about some tax-collecting ideas. Here, from John Steele Gordon in today’s Wall Street Journal, is a compelling attack on the practice of treating carried interest as capital gains. Would love to hear in the comments from some private-equity and hedge-fund folks why/how Steele isn’t right:

To defend the favored treatment of carried interest, private-equity and hedge-fund owners argue that their share of the customers’ gains is analogous to “founders stock,” which is granted to the founders of a company when it goes public, even though they may not have personally invested money in the venture.

This analogy is bogus when the companies in which a fund is invested are not actively managed. A founder has a bright idea. He works hard to convince others of its worth so that they will invest in it. He works hard to get the company off the ground, investing his time and his sweat equity in the business (not to mention the forgone income from the 9-to-5 job he could have had instead). He is risking a lot: a substantial portion of his working life, his reputation, his potential current income, etc.

What does a hedge-fund manager risk? His is an on-going business, not a start-up. His business is, in effect, giving investment advice to clients. If his advice nets to a profit he is rewarded with a portion of the gain. How does that differ from, say, a lawyer taking a case on a contingency basis and sharing in the award when the case is successfully settled or won? The lawyer is giving legal advice and being compensated for giving good advice. But that compensation is taxed as ordinary income.


Unlike Warren Buffett‘s phony self-example — where he ignored the corporate income tax paid by Berkshire Hathaway and thus claimed to pay a lower tax rate than his secretary — carried interest is a genuine case of the staff paying higher income-tax rates than the boss. And it is flat-out wrong. 

Jason DaCruz

Interesting take on lawyer-pay. I guess one could make that analogy for any sort of commission-based job.


Under the same assumptions, shoudn't one be taxed at standard federal rates when investing in the stock market?


I work at a hedge fund, and I agree, it is time for carried interest to be treated as normal income. It seems the politics of the current environment seem to be moving more and more towards taxing capital and labor equally.

Political Punnery

"Unlike Warren Buffett‘s phony self-example..."

What's phony about it? According to the Supreme Court, Mr. Berkshire Hathaway is a completely separate and totally existent person. His tax bill is his own, not Warren Buffet's.


Because Buffett is ignoring the corporate income tax that's taking a substantial share of the profits he's being taxed on. Since he's getting a more-or-less fixed percentage of Berkshire's profits, that amounts to a shell game: he'd be making a lot less, giving a lot more to the government, and be taxed at a much lower rate than his secretary if the corporate tax rate were 75% and his capital gains tax rates were 0. As it is now, for every $100 in profit Buffett's share of Berkshire makes, he's effectively making $50 between the two taxes.

If you'd prefer to insist that his personal tax rate is all that matters, then let's set the corporate tax rate to 0 and tax his capital interest as regular income. He'd personally be paying a lot more, and unless he lives in California would probably come out ahead.

Political Punnery

I think you've missed my point.

Seminymous Coward

The problem is classing any form of income as special, whether it's wages, capital gains, or commissions in one particular industry.


But the hedge-fund managers bought that tax break legally through campaign contributions, and their children will starve and/or freeze to death without it! Please won't anyone think of the hedge-fund children!

Johnny (@MoneyWonk)

I'm in the industry, and I agree that it should be taxed as ordinary income. What Mitt Romney and Ed Conard advocated last year on the campaign trail - that carried interest should be taxed at a lower rate to compensate them for the risk incurred - is completely false. They may invest a small amount of their own money, but the majority of their compensation comes in the 20% "carry" they take off the top of their investors' profits. So who is taking the risk and who should be given the favorable tax treatment for participating in the "creative destruction" of the private equity industry? The answer is the large pension funds and endowments that invest in private equity.

...it begs the question: where are all the customer's yachts?

John S

Stephen I am afraid you are misinformed on what PE Funds do if you are of the belief they simply give advice to buy a company to a client similar to how an attorney provides advice for a fee. First, they take risks with their personal money (most PE Funds co-invest along side their investors in their own funds), secondly many actively manage and operate the businesses they invest in either through board appointments to set the strategy and/or turnaround for the company or through appointing senior leadership. Much like your example above, many PE funds are managed by successful entrepreneurs who left a 9-5 job, worked hard to get their company off the ground investing time and sweat equity. They are the successful ones and are now implementing those lessons to often times broken enterprises in need of capital and expertise. They are taking risks with their time (which could be spent collecting a salary at a 9-5 job) but also with their money. Where is the logic to disincentivize risk taking on failed american enterprises? There are many other areas to cover but your argument that PE funds merely give advice and move on is not accurate. In your assertion above about the Fund manager he as an individual is likely taxed at ordinary income if he is an employee. My comments also speak nothing to a study performed which found taxing carried interest would provide enough additional income to fun the federal government for 3.5 hours! I also did not go into the unintended consequences of this "tax on the rich": who is really going to get hardest with this tax? Pension Funds, IRAs, 401ks, and retirement funds for mostly working class (9-5 jobs) Americans as they consist of the majority of the investors in a Private Equity model which will no doubt change (become more costly) if the mangers are disincentivized to seek annual returns for them (and depending on the legislation may be subject to the tax).



IMHO, you do this discussion a disservice couching the arguments as you do. If a PE manager invests his own funds then he is entitled to capital gains treatment of any gains on his own investment. Carried interest, on the other hand, is a transfer of assets from one entity (the investor) to the PE manager. From the manager's point of view, he has something he did not have before. Consequently, it is income, rather than gain.

The fact that changing the classification of carried interest will fund the government for 5 minutes or five years is irrelevant; the issue is fixing something to make it right. In addition, the impact on asset owners invested in PE is likewise irrelevant. Previous returns were artificially inflated because of an incorrect policy, future returns only reflect what should have been in the first place.


The current situation is a horrible injustice to the vast majority of non-fund manager Americans and MUST be fixed immediately if not sooner.

What some fund managers would have us believe is that somehow their work, their business minds and opinions are somehow intrinsically worth more than everyone else's and thus they are entitled to a significantly lower tax rate than the rest of us, which is an insult to humanity.

It is high time that interest income were treated EXACTLY(**) the same as "regular" value added employment income, regardless of how you "earned" it. In fact I'd argue that our preferential treatment of capital over labor is one of the leading reasons that our economic influence in the world has been on the decline for decades now. Sitting back collecting interest is by definition NOT adding value, and yet we clearly worship that practice here in the US of A. The only way for any economy to thrive and compete in a capitalist world is by adding value, i.e. "making stuff", be it goods or services. So those of us who add value need to be, um, valued more.

If I had millions of dollars socked away in various instruments that could yield enough interest and/or dividends to guarantee me a comfortable life, would I work? HELL NO, all I'd do is travel the world, take art and cooking and language classes etc, in other words lose myself in a vast ocean of non-value-add activities.

And yet there are those who would have us believe that the poor, oppressed billionaires of the world simply couldn't afford to live if their annual cash farming activities were taxed at more than, say, half the rate that the typical hard working professional has to pay. We hear those same people whining all the time about how taxing their interest is tantamount to "punishing success"....so you'd rather punish WORK then? What an excellent motivator! That sounds like a winning formula to keep America competitive in the global economy!

The majority of us who have to work for every penny of our income have to be valued as citizens and as taxpayers AT LEAST as much as those who have vast sources of passive income and/or those who have to endure the sacrifice of the insanely lucrative and perk-filled world of fund management (sniff).

Note to fund managers: I have no doubt that you work long, stress-filled hours. But then again so do I, and yet it is highly unlikely that I earn more than a small fraction of what you do. So you get NO sympathy from me come April 15th. Pay up or hit the bricks.

(**) Seniors, retirees, LTD etc should be able to get the first $X of annual interest tax-free, indexed for inflation, after which point the regular income tax rates would kick in.



You seem to be completely unaware that interest is already taxable as ordinary income.


The WSJ article makes a compelling argument by saying the carried interest is unlike capital gain because nothing is put at risk. Moreover, it's undoubtedly meant to remunerate the manager for his services, which is ordinary income-generating activity. But the article should have stopped there. The above quote is unhelpful: how hard you have to work for it is not the point, and if anything, less work makes it look more like investment activity.

The comparison to founders stock is bogus for a different reason. The reason founders stock gives rise to capital gain is that it has little or no value when issued. If it has significant value when issued in exchange for services, that absolutely gives rise to ordinary income.

John S.

"The reason founders stock gives rise to capital gain is that it has little or no value when issued. If it has significant value when issued in exchange for services, that absolutely gives rise to ordinary income."

Jeff, carried interest has absolutely no value "when issued". If the manager does not perform in creating value i.e. a profit, there is no income earned. The income earned is when the manager successfully manages the risk of the investment including: placing his/her name on recourse debt, subjects itself to litigation and cost over run risks and the general market risk of investment activity. The income is not earned until the partnership is liquidated and the profits are distributed. The service activities provided by PEs such as management and operations are properly taxed as ordinary income. It is no different than two partners who want to open a hamburger stand. One is an investor who wants to earn a return on his money the other is a cook who knows how to create the best burgers in town. They create the business in a partnership, become successful, sell it and collect a profit. The cook might collect a salary for running the restaurant and be taxed at ordinary income. Should the cook's profit from the sale of his equity interest in the restaurant also be taxed at ordinary income? If you think yes, many would argue you are removing incentives from entrepreneurial endeavors. Lawmakers on both sides of the aisle seem to agree the country needs to encourage entrepreneurial investment..it would be nice to see them do something about it instead of placing more road blocks. Odd that Dubner would pose the question the way he did when one of the thesis's of his books was people respond to incentive. How is taxing risk taking and entrepreneurial investment an incentive?



I would like to see reform in Capital Gains......a gradual reduction in the tax depending on the number of years you hold a position, going to zero after 10 years and taxed at regular rates for income held less then a year. This would be fair and would help stablize a scary equity market.

Czar of Chasm

I read Steele's article yesterday, and thought it was lacking. For sake of simplicity, let's assume all capital gains discussed here are long term (ie., paid out at closing, and not annually). Carried interest is nothing more than the equivalent of giving stock options to employees. The employee only benefits if the stock price grows. We tax employee stock options as capital gains. So why the difference? I'd suspect jealousy.

How many of you would invest in a gov't run VC fund, where the managing partner was a GM-15, earning about $130k annually? Do you think said person would work as hard at earning you returns as would someone who gets a cut of the action? I'm not knocking gov't employees here, but question if they have sufficient incentive to do well.

Who will pay for this in the end? Each fund's investors. Fund managers will insist on a greater equity stake, or a greater upfront managing fee. Or they will "borrow" money from fund investors so it is their's at risk, and co-invest in the fund. End result, less returns for investors. I'm not sure I agree that is best for everyone involved. Except for the lawyers; this will create new work for them.