Jan. 30 (Bloomberg) -- The release of Mitt Romney’s tax returns last week gave the nation a crash course in the mysterious “carried interest” that was said to allow him to pay 15 percent on millions of dollars of capital gains. Unfortunately, more heat than light was shed on what a carried interest really is.
A carried interest is an ownership interest in a partnership that entitles the partner to a percentage of the profits but doesn’t obligate the partner to provide any capital. It is the other partners who provide the necessary capital, and they are thereby “carrying” the partner who does not.
A carried interest can arise in many contexts. It is fairly common on Main Street. My dad was a veterinarian who, as he got up in years, brought a young veterinarian into his practice. Although my dad did not call it that, the young veterinarian had a carried interest -- that is a percentage of the profit with no obligation to invest capital.
Income from being a veterinarian is ordinary income, and thus the young partner with the carried interest paid tax on his share of the partnership income at ordinary income rates. If the underlying activity of the partnership, however, is an activity that produces capital gains, then the partner with the carried interest will have a share of the underlying capital gains and will pay tax on that income at a 15 percent rate.
That is the situation with a private-equity partnership whose business is to buy companies and (it hopes) sell those companies a few years later at a profit. So, the only difference between an investor with a carried interest in a private-equity partnership and my dad’s young veterinary partner is that the underlying activity in private equity produces capital-gain income, and Congress has chosen to tax capital-gain income at 15 percent.
For a couple of years after President Ronald Reagan’s tax reforms were adopted in 1986, capital gains were taxed at the same rate as ordinary income. That was very unusual. In most recent years, capital gains have been taxed at a lower rate than ordinary income, and the differential was increased by the Bush tax cuts. You can argue whether capital gains should be taxed at 15 percent, but that is a big issue having only a little to do with carried interest.
In all the years that capital gains have enjoyed a favorable tax rate, there has been a simple definition of what is a capital gain. It is simply gain on the sale of investment property, such as stock. The distinction between capital gain and ordinary income has never been based on the amount of sweat that went into producing the income. The workaholic investor who spends 60 hours per week researching stocks still earns capital gains that are no different, in the tax law, from the gains of an investor who gives little thought to his portfolio.
Bill Gates has a capital gain when he sells Microsoft Corp. stock even though, by most accounts, Microsoft would not exist without his considerable effort. Similarly, the distinction between capital gains and ordinary income has never been based on the amount of money invested or, indeed, whether there was any investment at all. An entrepreneur who starts a business with no investment (or more likely an investment by someone else with money) still generates capital gains on the sale of her business, and it is sometimes said that this fact accounts for the vibrancy of the tech economy in the United States.
What then would be the basis for saying that a private-equity executive with a carried interest should have his percentage of the capital gain from the sale of an underlying investment recharacterized as ordinary income? Is it because he sweats and the other investors don’t?
Well, maybe, but what about the full-time investor who sweats over his stock portfolio or the entrepreneur who slaved over her startup business. It is hard to make a distinction based on effort.
Plus, most private-equity executives earn large cash salaries that are taxed as ordinary income. Do we have to value the executive’s effort and see if it exceeds her cash salary, and then attribute that excess to the carried interest?
Tax Law Perspective
From the perspective of tax law, it just doesn’t make sense to have a tax distinction based on the sweat of the private-equity executive. A distinction based on the fact that the private-equity executive with the carried interest provides no capital to the partnership seems hard, too.
Do we really want a tax law in which only people who already have money can earn a capital gain? And, if earning a capital gain requires an investment, then how much? Does it have to be a big investment? Can it be borrowed from the other partners? Isn’t a carried interest in effect just a loan from the moneyed partners?
These are difficult questions that affect the entire structure of capital-gains taxation -- not just carried interest. It would be very hard to draw a fair line between the type of private-equity investment that is deserving of capital gain treatment and that which is not.
It is perhaps not an accident that the carried interest discussion is taking place in the political arena -- over Mr. Romney’s tax returns -- rather than the worlds of tax law or tax policy, and that the advocates of taxing carried interest at higher rates are not tax experts who understand the complexity of the issue and the difficulty of drawing fair lines.
(J. William Dantzler Jr. is a partner at law firm White & Case LLP and head of its global tax practice. The opinions expressed are his own.)
Read more opinion online from Bloomberg View.
To contact the editor responsible for this article: Katy Roberts at email@example.com.