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?


The difference is that hedge fund managers are allowed to pay the lower tax rate for profits derived from investing (mostly) *other people's money*, not their own, as you do when you buy stock for yourself and pay the lower capital gains tax.


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.


This is the sensible position when you consider the reason for the lower rate on capital gains. The lower rate was instituted in the late 70s/early 80s to compensate investors for the wealth lost during their holding time due to inflation, i.e. you bought at $80, sold ten years later at $100, but meanwhile the dollar has lost 10% of its value.
To complete the modernization of this, capital gains should be back-indexed for inflation using FIFO accounting. A penalty should be incurred if stocks are held for some short amount of time, e.g. a day or a week, thus penalizing the robo-traders that devastate every other member of the stock 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.



The question of whether carried interest should be taxed as ordinary income gets even more interesting when Management Fee Waivers are introduced. The Management Fee Waiver allows a Fund Manager to "waiver" his or her agreed upon management fee and then shuffle that owed management fee into the fund instead of putting up capital for him or herself. Thus, the Management Fee Waiver allows a fund manager to avoid paying ordinary income tax on the management fees, instead hoping to only pay capital gains on the returns when divestment occurs.

Now, it seems pretty clear that the fund manager is taking on additional risk by employing this tactic (ie the investments could go south, causing loses for both the manager and investors, rather than just taking the management fees as a regular payment), so on the surface it appears that the manager should be compensated for the additional risk. However, what is the added benefit to the economy or to investors in this arrangement? The money has to be invested no matter what (per the terms of the manager's commitment), so this is merely a calculated risk by the manager to avoid paying ordinary income taxes by essentially investing his or her income before it can be taxed.

I would personally love the opportunity to take a portion of my paycheck and have it diverted before taxes to my investment portfolio and not have any of the restrictions that are set up for retirement accounts.



What you are describing is actually a "profits" interest, which are typically given capital gains treatment. Think of it this way -- the business enterprise must have X in available capital to conduct its business, which amount includes the management fee (Y) to run the business enterprise. If the partner in the business who is owed the fee is willing to put his fee at risk and be paid after the return of original capital, then they are granted capital gains treatment.

This benefits the business and the investors because the business needs less total capital (X minus Y) to operate.


I'm not sure what you mean by a "'profits' interest" or how that relates to what I mentioned about waiving management fees.

And I have thought about what you describe and I don't see how the waiver makes it so less capital is required for the fund. The amount X is fixed from the beginning of the partnership as the total commitment amount of the fund, which includes management fees (Y) to be paid. So when Y is paid to from the LPs to the GP, that is credited as a capital drawdown from X. When Y is waived, it doesn't mean less capital is contributed, it just allows for Y to be directly contributed to the fund, without going to the GP first. This allows Y to bypass being taxed at ordinary income and instead be taxed when it is distributed from the fund to the investors. If Y isn't waived and then capital is called, the GP still has to provide his or her pro rata share of the call, so the amount of total capital at use remains the same. The waiver is merely an accounting trick to avoid ordinary income taxes. Yes, that capital is put at risk, but that risk doesn't add anything appreciable to the partnership.

Now, it could be argued that by waiving management fees, LPs are able to hold on to their capital a little longer than they otherwise would, but that is only a small benefit provided to investors while allowing the manager to avoid higher tax rates.


theo d

Carried-interest proponents get away with their faulty logic (and resultant unfair tax breaks) for the same reason a dog licks its nether regions. Because they can.

James Walker

You are missing an important aspect of the biggest reason of all. All income is taxed at ordinary income tax rates except that which is given a break (an incentive). Managers of funds don't need such incentives since they are not starting up a business or expanding one. They are being compensated for managing an asset, just like a property manager or a bookkeeper. Even those who start up corps, pay ordinary income on all their compensation and taxable benefits, just not on their investment/equity share.

also quite strange, because those who do what hedge fund managers do in the real estate syndication biz, promoters, have to pay ordinary income ( Sol vs. Diamond) why a difference for the two industries? only one answer Goldman Sachs has more money to pay lobiests.
A related and bigger question, should fund managers be able to make 83(b) elections, as company starters can- if so, then the situation nearly gets to the same place, the bulk of the profits are taxed as cap gains. So should 83 (b) elections be eliminated , too? I think so. not needed to get people to work - a huge, complicated loophole


Caleb B

This issue is a red herring. The public outrage over carried interest believes that if only these greedy hedge fund guys would pay normal rates, our budget would be fixed. It won't.

Using the CBO estimates (which are laughably optimistic), an average deficit of $741 billion is projected until 2023. To balance the budget so the deficit is zero, taxes would need to be raised an average 43% over the next 11 years.

So earners making over $75k/yr already pay 85% of all taxes paid, but their taxes are going to need to go up by 43% just to break even on the deficit. Obviously, you could go after only the high income people ($1 million+), but in 2010, these people only had a total of 13% of all income made...so it's not enough.

A tax rate of 75% of total income (no marginal rate, but total rate) would break even the deficit if the tax applied only to earners over $200k/yr, but I can't imagine the damage that would do economically.


Seminymous Coward

Just because it doesn't fix the deficit all by itself in a single step, doesn't mean that we can't tax these people fairly. You were the first person to even mention the deficit.

Caleb B

@S C

My point is that they could be taxed as regular income and the affect on a national deficit would be negligible. Carried interest is a distraction.

Point two: Please define fair share for all income levels. Some would argue "fair" would be everyone pays the same rate with no deduction/exceptions, but I'm certain that sounds like complete lunacy to 50.4% of voters.

Caleb B

More simple explanation: using 2010 numbers from the IRS, we could tax everyone making more than $500 at 100% and we would still not break even on the deficit. To balance the budget, people making between $50k and $100k need their taxes raised as well. That is, unless some spending cuts can be made.

Walter J Smith

Re: "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."

The example is not phony! The argument that Warren Buffet's taxes are the same as Berkshire Hathaway's taxes is specious. In 2010, the US Supreme Court ruled that corporations are people. Corporations are citizens.

The specious argument is designed to hoodwink the unsuspecting into a self-deception: my corporation is a person for tax purposes, but not for moral purposes.

Good heavens. What will the professional self-deceivers come up with next?

Then, again, maybe this is just another way Mother Nature and her consort, God, are playing with the wits of the professionally self-stupified: allow them enough self-deception techniques to take them out of the gene pool when they self-destruct as a sub-species. Because such people are sub-human. Even if they are legal persons.



Economists sometimes point out that capital is taxed at a lower rate than labor because it is so much easier for people to move their money to avoid capital gains taxes than it is for workers to move their labor beyond the jurisdiction of the relevant income tax. In other words, the elasticity of the supply of capital with respect to taxes is much greater compared to that of labor. This means that the dead weight loss created by any taxation is much greater for capital than for labor. To minimize this, capital is taxed at a lower rate than labor.

To the extent that hedge funds/PE firms are not investing their own money, I cannot see how it can shown that they are providing capital rather than labor. Whilst their compensation for management services and investment advice is calculated with reference to performance (much like the compensation of many other professionals taxed at income tax rates), it remains compensation for their time, effort and expertise. In other words, their labor.

The tax system is meant to achieve a balance between the goals of equity and efficiency. If carried interest is in fact compensation for labor, then its current treatment as capital gains is inequitable.

On the efficiency side, policy makers should be concerned with the effect that this part of the tax regime is having on the supply of capital. Clearly, greater supply of capital creates investment, allowing the economy to grow and jobs to be created. If taxing the compensation of management of PE firms/hedge funds as ordinary income would have a significantly negative effect on the supply of investment capital in the economy as a whole, then there may be a good argument to be made that the current tax treatment should be preserved.

I am, however, skeptical that this would be so. After all, there are many investment professional competing to manage capital through various models who are currently providing their services despite being taxed at income tax rates. Should hedge funds/PE firms significantly raise their fees in response to changes in the way they are taxed, investors would still have plenty of choices in seeking out the best expected fee-adjusted return.