Carried interest: “a share of any profits that the general partners of private equity and hedge funds receive as compensation, despite not contributing any initial funds. This method of compensation seeks to motivate the general partner (fund manager) to work toward improving the fund’s performance.”1 For private equity managers, this profit is usually taxed as capital gains as opposed to regular income tax. To those who are not well versed in the tax code, the difference between the two could easily be over 15% of the net profit. And this is astronomical. The private equity managers have been enjoying this tax benefit since the beginning of time; however, this could change with a recent federal court decision–Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund.2
To understand this decision, we must first understand why carried interest is taxed as capital gains. Unlike hedge funds, private equity funds usually invest in long-term investments, which qualify for long-term capital gains in terms of taxes.3 The IRS sees this investment activity as “passive,” similar to a regular long-term stock investment.4 Therefore, it makes sense to tax a private equity fund’s profit at the lower rate.5 Because carried interest is essentially a portion of the profit, it is also taxed at the lower rate.6
Now let’s get to the decision. In Sun Capital Partners III, the 1st Circuit panel held that for the purpose of 29 U.S.C § 1301(b)(1), Sun Fund is a “trade or business.”7While this holding seems to be only limited to pensions and how firms that acquired pensions should be defined, it could also “blow away a legal-fiction that private equity funds are passive investors who do not actively control the company they buy.”8 As a matter of fact, this tax benefit has been seriously debated in the political forums. Steve Rosenthal, a political strategist, mentioned that “private equity funds are in the business of developing companies and should be treated like real estate developers for tax purposes and pay ordinary income tax rates.”9 According to President Obama’s budget plan, removing carried interest’s incidental tax benefit could increase the tax revenue by as much as 16-billion dollars over the next decade.10
The view that a private equity fund manager’s carried interest should be taxed as an income as opposed to capital gains seems to have gathered momentum in Europe as well. As recent as August of 2013, Sweden’s tax administration decided that EQT, a private equity fund, and its executives need to pay the government the difference between the lower capital gains rate and the higher income tax rate because the government re-characterized the private equity managers’ carried interests as salaries.11 While the equity managers in Sweden are currently “working” with the government to resolve this issues, this re-characterization seems to be the new status quo there.12
On the other hand, outside of the traditional economics theory that a higher tax rate could discourage private sector’s activities, the argument that a private equity fund is a “trade or business” is also logically flawed. Normally, a trade or business is defined as good and services provided to a third party other than the owner (or collective owners). For example, when a restaurant owner hires chefs, servers, busboys, etc. to work for him, they provide a service to a third party patron.13 Serving food is a “trade or business” of the owner and the restaurant. In the case of private equity funds, the fund hires a manager to act on behalf of the fund and invest in firms that he or she thinks is undervalued.14 The job of the managers is to manage the fund, and the management fee is taxed like an income tax.15 The fund itself, however, does not have a particular “trade or business” other than fueling firms with capital. As Andrew W. Needham, a partner at Cravath, Swaine, & Moore, illustrated in his colorful analogy, “just as my hiring a lawn mower doesn’t make me a lawn mower, my hiring the general partner as my money manager doesn’t make me a money manager.”16 With that logic, carried interest, designed to incentivize the managers to perform reasonably well, is still derived from the investment activities; thus, it should be characterized as “capital gains.”
In my opinion, there is no easy way to circumvent this problem in the long run, especially because the federal financial problem is becoming more and more relevant (Congress has been shut down for a week now). While Needham’s logic is seemingly sound, the IRS is not known to be the most logical government entity in America. Further, we tax certain investment activities as income already (namely, short-term investments), and, logically, they are very much “investments” and “capital gains” as well. No matter what the government chooses to do, it should act sooner rather than later. The fast-moving small business world cannot afford the potential costs if the private equity funds managers take a “wait and see” approach.
Carried interest Definition, Investopedia.com, http:// www.investopedia.com/terms/c/carriedinterest.asp (last visited Oct. 8, 2013). ↩
Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund, 724 F.3d 129 (1st Cir. Mass. 2013). ↩
Richard Rubin, Carried Interest Tax Break Risks Being Undercut by Court, Bloomberg, available at http://www.bloomberg.com/news/2013-09-25/carried-interest-tax-break-risks-being-undercut-by-court.html. ↩
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Tax Attack, The Economists (Aug. 24, 2013), http://www.economist.com/news/finance-and-economics/21584022-leveraged-buy-outs-face-legal-scrutiny-tax-attack. ↩
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Rubin, supra note 3. ↩
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The Economists, supra Note 4. ↩
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Steven M. Rosenthall and Andrew W. Needham, Tax PE Funds and Their Partners: A Debate on Current Law, Tax Notes, available at http://www.taxpolicycenter.org/UploadedPDF/904592-TN-private-equity-debate-rosenthal.pdf. ↩
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