Structure of a private equity or hedge fund, which shows the carried interest andmanagement feereceived by the funds investment managers. Thegeneral partneris the financial entity used to control and manage the fund, while thelimited partnersare the individual investors who receive their return ascapital interest.

Carried interest, orcarry, in finance, is a share of the profits of an investment paid to theinvestment managerin excess of the amount that the manager contributes to the partnership, specifically inalternative investmentsprivate equityandhedge funds). It is aperformance fee, rewarding the manager for enhancing performance.3

The managers carried-interest allocation varies depending on the type of investment fund and the demand for the fund from investors. In private equity, the standard carried-interest allocation historically has been 20% for funds making buyout and venture investments. Notable examples ofprivate equity firmswith carried interest of 25% to 30% includeBain CapitalandProvidence Equity Partners.

In private equity, the distribution of carried interest is directed by adistribution waterfall: to receive carried interest, the manager must first return all capital contributed by the investors and, in certain cases, a previously agreed-upon rate of return (thehurdle rateor preferred return) to investors.4Private equity funds distribute carried interest to the manager only upon a successful exit from an investment, which may take years. The customary hurdle rate in private equity is 78% per annum.citation needed

In a hedge fund environment, carried interest is usually referred to as a performance fee and because it invests in liquid investments, it is often able to pay carried interest annually if the fund has generated a profit. They have historically centered on 20%, but have had greater variability than those ofprivate equity funds. In extreme cases performance fees reach as high as 44% of a funds profits but is usually between 15% and 20%.5

Carried interest is a share of the profits of an investment paid to theinvestment managerin excess of the amount that the manager contributes to the partnership, specifically inalternative investmentsi.e.,private equityandhedge funds. It is aperformance feerewarding the manager for enhancing performance.3

The origin of carried interest can be traced to the 16th century, when European ships were crossing to Asia and the Americas. The captain of the ship would take a 20% share of the profit from the carried goods, to pay for the transport and the risk of sailing over oceans.67

Historically, carried interest has served as the primary source of income for manager and firm in both private equity and hedge funds. Both private equity and hedge funds tended to have an annualmanagement feeof 1% to 2% of committed capital per year; the management fee is to cover the costs of investing and managing the fund. Some have suggested the management fee in hedge funds should be treated as ordinary income rather than capital gains which is treated at a lower tax rate. As the sizes of both private equity and hedge funds have increased, management fees have become a more meaningful portion of the value proposition for fund managers as evidenced by the 2007initial public offeringof theBlackstone Group.8

The taxation of carried interest has been an issue since the mid-2000s, particularly as the compensation earned by certain investors increased along with the sizes of private equity and hedge funds. Historically, carried interest has been treated as acapital gainfor tax purposes in most jurisdictions. The reason for this treatment is that a fund manager would make a substantial commitment of his own capital into the fund and carried interest would represent a portion of the managers return on that investment. While hedge funds typically trade their investments actively, private equity firms tend to hold their investments for many years. Thus, capital gains from private equity funds typically qualify as long-term capital gains, which receive favorable tax treatment in many jurisdictions. Critics of this tax treatment seek to disaggregate the returns directly related to the capital contributed by the fund manager from the carried interest allocated from the other investors in the fund to the fund manager.8

Because the manager is compensated with carried interest, the bulk of his income from the fund is taxed as areturn on investmentand not as compensation for services. This tax treatment originated in the oil and gas industry of the early 20th century, when the actual oil exploration companies, which used financial partners investments, had their profits taxed at the capital gains rate. This has been lower than the rate for ordinary income for much of the 20th century, in order to encourage risk and entrepreneurship. The logic was that the financial partners sweat equity had entailed the risk of loss, if their exploration did not pan out.9

Typically, a partner is not taxed upon receipt of a carried interest because it is difficult to measure thepresent valueof an interest in future profits.10In 1993, theInternal Revenue Serviceadopted this approach as a general administrative rule,11and again in regulations proposed in 2005.12Instead, the partner is taxed as the partnership earns income. In the case of ahedge fund, this means that the partner defers taxation on the income the hedge fund earns, which is typically ordinary income or possibly short-term capital gains, which are taxed the same as ordinary income due to the nature of the investments most hedge funds make.Private equity funds, however, typically invest on a longer horizon, with the result that their income is long-term capital gain, taxable to individuals at a maximum 20% rate. Because this compensation can reach enormous figures in the case of the most successful funds, concern has been raised in both theU.S. Congressand the media, that managers are taking advantage oftax loopholesto receive what is effectively a salary without paying the ordinary 37% marginal income tax rates (updated to reflect the Tax Cuts and Jobs Act of 2017) a high-income person would have to pay on such income.8As of September 2016updatethe loopholes total tax benefit for private-equity partners is estimated to be about $2 billion per year up to 14 or 16 billion dollars.9

To address this concern,introducedH.R. 2834on June 22, 2007, which would have eliminated the ability of investment-advisers to receive capital-gains tax treatment on their income. On June 27, 2007,Henry Paulsonsaid that altering the tax treatment of a single industry raises tax policy concerns, and that changing the way partnerships in general are taxed is something that should only be done after careful consideration, although he was not speaking only about carried interest.13In July 2007 theU.S. Treasury Departmentaddressed carried interest in testimony before theU.S. Senate Finance Committee.14U.S. RepresentativeCharles B. Rangelincluded a revised version of H.R. 2834 as part of the Mother of All Tax Reform and the 2007 House extenders package.

In 2009, theObama Administrationincluded a line item on taxing carried interest at ordinary income rates in the 2009 Budget Blueprint.15On April 2, 2009, Congressman Levin introduced a revised version of the carried interest legislation asH.R. 1935. Proposals were made by the Obama Administration for the 2010,162011,17and 201218budgets.

Favorable taxation for carried interest became an issue during the2012 Republican primary race for president, because 31% of presidential candidateMitt Romneys 2010 and 2011 income was carried interest.19On May 28, 2010, the House approved carried interest legislation as part of amendments to the Senate-passed version ofH.R. 4213.20On February 14, 2012, Congressman Levin introducedH.R. 4016.20

On February 26, 2014,House Committee on Ways and MeanschairmanDave Camp(R-MI) released draft legislation to raise the tax on carried interest from the current 23.8 percent to 35 percent.212223In June 2015, Sander Levin (D-MI) introduced the Carried Interest Fairness Act of 2015 (H.R. 2889) to tax investment advisers with ordinary income tax rates.24

As of 2015updatesome in the private equity and hedge fund industries had been lobbying against changes, being among the biggest political donors on both sides of the aisle.25

In June 2016 Hillary Clinton said that if Congress does not act, as president shell ask the Treasury Department to use its regulatory authority to end a tax advantage.26

TheFinance Act 1972provided that gains on investments acquired by reason of rights or opportunities offered to individuals as directors or employees were, subject to various exceptions, taxed as income and not capital gains. This may strictly have applied to the carried interests of many venture-capital executives, even if they were partners and not employees of the investing fund, because they were often directors of the investee companies. In 1987, theInland Revenueand the British Venture Capital Association (BVCA27) entered into an agreement which provided that in most circumstances gains on carried interest were not taxed as income.

TheFinance Act 2003widened the circumstances in which investment gains were treated as employment-related and therefore taxed as income. In 2003 the Inland Revenue and the BVCA entered into a new agreement which had the effect that, notwithstanding the new legislation, most carried-interest gains continued to be taxed as capital gains and not as income.28Such capital gains were generally taxed at 10% as opposed to a 40% rate on income.

In 2007, the favorable tax rates on carried interest attracted political controversy.29It was said that cleaners paid taxes at a higher rate than the private-equity executives whose offices they cleaned.30The outcome was that the capital-gains tax rules were reformed, increasing the rate on gains to 18%, but carried interest continued to be taxed as gains and not as income.31

Fleischer, Victor (2008). Two and Twenty: Taxing Partnership Profits in Private Equity Funds.

Batchelder, Lily.Business Taxation: What is carried interest and how should it be taxed?. Tax Policy Center

Hedge Funds and Other Private Funds: Regulation and Compliance

Hurdle Rate explained

James M. Kocis; James C. Bachman, IV; Austin M. Long, III; Craig J. Nickels (2009).

The term carried interest goes back to the medieval merchants in Genoa, Pisa, Florence and Venice.

Marples, Donald (2 January 2014).Taxation of Hedge Fund and Private Equity Managers

Alec MacGillis (7 September 2016).The Surreal Politics of a Billionaires Tax Loophole. Pro Publica

Rev. Proc. 2001-43, 2001-2 C.B. 191, Internal Revenue Service, U.S. Dept of the Treasury.

Prop. Treas. Reg. section 1.83-3(l), 70 Fed. Reg. 29675, 29680-29681, Internal Revenue Service, U.S. Dept of the Treasury (May 24, 2005).

Ryan J. Donmoyer; Kevin Carmichael (June 27, 2007).Paulson Warns of Unintended Fallout in Taxing Funds (Update2).

07.11.07 Testimony Solomon on Carried Interest.doc

[1]. See page 122 of the White House version of A New Era of Responsibility Renewing Americas Promise.

TPC Tax Topics 2010 Budget Tax Carried Interest as Ordinary Income.

TPC Tax Topics 2011 Budget Page Tax Carried Interest as Ordinary Income.

TPC Tax Topics 2012 Budget Tax Carried Interest as Ordinary Income.

H.R. 4016: Carried Interest Fairness Act of 2012. Democrats of theUnited States House Committee on Ways and Means. Archived fromthe originalon 2014-04-18

Alden, William (26 February 2014).House Proposal Would Raise Taxes on Private Equity Income.

Norris, Floyd (6 March 2014).Republicans Tax Plan Awkwardly Aims at Rich.

Camp Releases Tax Reform Plan to Strengthen the Economy and Make the Tax Code Simpler, Fairer and FlatterUnited States House Committee on Ways and Means

Baldwin, Levin Introduce Bill to Close Carried Interest Loophole. Ways and Means Committee Democrats U.S. House of Representatives. 25 June 2015. Archived fromthe original

Alex Lazar (10 September 2015).Attacks on low taxes for hedge fund managers will face fierce fight. The Center for Responsive Politics

Przybyla, Heidi M. (June 16, 2016).Clinton says shell call Trump unfit to handle economy.

March 20, 2009, at theWayback Machine(PDF).HM Revenue and Customs.

March 20, 2009, at theWayback MachinePDF).HM Revenue and Customs. 9 October 2007.

Lily Batchelder,Business Taxation: What is carried interest and how should it be taxed?,

Lily Batchelder,What are the options for reforming the taxation of carried interest?,

Peter R. OrszagThe Taxation of Carried Interest: Statement of Peter R. Orszag, Director, Congressional Budget Office, before the Committee on Finance United States Senate,

Chris William SanchiricoThe Tax Advantage to Paying Private Equity Fund Managers with Profit SharesWhat is it? Why is it Bad?, University of Chicago Law Review, Vol. 75, pp.10711153 (2008)

History of private equity and venture capital

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