Carried Interest

The Carried Interest Fairness Act of 2015, introduced on June 25, 2015, by then-House Ways and Means Committee Ranking Member Sander Levin (D-MI) and U.S. Senator Tammy Baldwin (D-WI), would close the carried interest loophole and ensure that income earned managing other people's money is taxed at the same ordinary income tax rates as that of the vast majority of Americans.

The Carried Interest Fairness Act of 2015 provides that the “carried interest” compensation received by investment fund managers will be taxed at ordinary income rates and treated as wage income subject to employment taxes. In exchange for providing the service of managing their investors’ assets, fund managers often take a portion of a fund’s profits, or a carried interest, usually equal to 20 percent of such profits. The bill clarifies that this income is subject to ordinary income tax rates rather than the much lower capital gains rate.

Why is Congress concerned about this issue?

Many investment funds are structured as partnerships in which investors become limited partners and the funds’ managers are the general partner. The managers often take a considerable portion of their compensation for managing the funds’ investments as a share of the funds’ profits; this profits interest is often referred to as a “carried interest.”

Partnership profits are not taxed at the partnership level; instead, partners are taxed on their share of partnership income. The character of that income (capital or ordinary) is determined at the partnership level and “flows-through” to the partners. Where a significant portion of an investment fund’s profits are long-term capital gains, investment managers who are compensated with a carried interest are able to take advantage of the 15 or 20 percent longterm capital gains rate on income they receive for the performance of services. Essentially, they are able to pay a lower tax rate than other Americans on income from their work simply because of the structure of their firm.

What does this legislation do?

This bill clarifies that any income received from a partnership, capital or otherwise, in compensation for services is considered ordinary income for tax purposes. As a result, managers of investment partnerships who receive a carried interest as compensation will pay ordinary income tax rates rather than capital gains rates on that compensation. The capital gains rate will continue to apply to the extent that a manager’s allocation of capital gain income represents a return on capital they have actually invested in the partnership.

What kinds of investment firms will be affected?

This bill serves the broader goal of tax fairness. The principle at work is that compensation for services should be treated as ordinary income and taxed accordingly, regardless of its source. Any investment manager that takes a share of an investment fund’s profits as its compensation (i.e., in the form of a carried interest) will be affected. This rule will apply to investment management firms without regard to the type of assets they manage, whether they are financial assets or real estate. The key issue is the form of compensation (i.e., a profit’s interest given for investment management services), not the type of assets the firm is managing, its investment strategy, or the amount of compensation involved.

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