What Is Carried Interest, Anyway?

by Will Ashworth | June 14, 2012 8:00 am

If you do a Google search for “Mitt Romney carried interest,” 9,770 results appear.

That’s not a huge amount in the world of search. Yet it’s clearly going to be a big topic of conversation[1] as we move closer to November. Obama wants to get rid of it, and Romney won’t say what he thinks, though it’s pretty clear he knows which side his bread is buttered on.

Regardless of who believes what, it’s constructive for voters to understand the issue before they step into the voting booth. Knowing how carried interest is created and when taxing it at lower rates is warranted should be important to all Americans — not just those directly affected by it.

According to the Tax Policy Center at the Urban Institute and Brookings Institution:

“Carried interest is a right that entitles the general partner (GP) of a private investment fund to a share of the fund’s profits. Typically, the GP contributes 1 to 5 percent of the fund’s initial capital and commits to managing the fund’s assets. In exchange, the GP receives an annual management fee of 2 percent of the fund’s assets plus a ‘carried interest’ of 20 percent of the fund’s profits that exceed a certain ‘hurdle’ rate of return.”

Although the media generally focus on private equity firms when discussing this controversial issue, carried interest also applies to any investment partnership, including those in real estate, hedge funds, oil and gas, timber and many other sectors.

The Tax Policy Center suggests there’s both an “investment share” and a “compensatory share” in any partnership, with the return of capital to the general partner reflecting the GPs investment in the partnership (investment share) and the compensatory share representing the implicit loan by the limited partners to the GP, which represents performance bonuses.

In a typical 2-and-20 situation, the GP receives an annual 2% fee for managing the partnership’s assets and 20% of the future profits. The 2% fee is taxable as income at the top tax rate of 35%, while the 20% performance bonus (“carried interest”) is taxed at the lower rate of 15%. The Obama camp believes the entire performance bonus, or compensatory share, should be taxed at the higher rate of 35%.

Real estate professionals object to this idea for several reasons, but the main one is that the general partner assumes the risk for all partnership liabilities and lawsuits in return for that carried interest, while the limited partners, in most cases, are limited in their liability.

Typically, a GP will front the money necessary to move a transaction to the point where limited partners can be found to close the deal, and though the GP is reimbursed for those expenses through a return of capital and no longer has actual skin in the game, the risks remain. Therefore, in the eyes of real estate people, carried interest shouldn’t be considered earned solely by labor despite the fact it the GP has no capital invested in the partnership. They have a point.

The problem here is the tax rules. For years, experts have opined on how to simplify taxation in America, yet it’s still extremely complicated. The carried-interest issue is a perfect example of why our tax structure is a failed system. Even if we could mathematically determine the portion of a general partner’s compensation that is labor versus investment (implicit or actual), which is highly unlikely, that still doesn’t solve the problem of fairness.

A dollar earned of any description should be taxed the same. Why should a retiree pay more for interest earned in a savings account than in a dividend fund? Why should your gains from an investment decision be taxed at a lower rate than the janitor who mops the floor at your son’s or daughter’s local school? Why should Warren Buffett pay less tax than his secretary? The solution is to implement a flat tax that treats all income the same no matter how it’s earned, combined with a consumption tax. Politicians clearly aren’t ready to do that, so the debate on carried interest will continue through November and beyond.

Explaining what carried interest is can be tricky, but I hope I’ve done a decent job. Explaining whether or when it’s warranted is even trickier.

As of this writing, Will Ashworth did not own a position in any of the stocks named here. 

Endnotes:
  1. topic of conversation: http://www.huffingtonpost.com/2012/05/25/carried-interest-mitt-romney_n_1546495.html

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