Why Carried Interest Is a Capital Gain

Steve Judge is the president and chief executive of the Private Equity Growth Capital Council.

The current debates on tax reform and government spending levels have often focused on raising taxes on carried interest. While many, including a recent opinion piece in The New York Times by Lynn Forester de Rothschild, have homed in on carried interest to raise revenue, little discussion has focused on how carried interest actually functions and why it was treated as a long-term capital gain in the first place.

Furthermore, changing the tax treatment of carried interest would not generate the significant revenue needed to close our huge budget shortfall. Some of the atest proposals on carried interest would deprive private equity, venture capital and real estate partnerships of the same long-term capital gains treatment available to other kinds of businesses - and would only pay for merely 3.1 hours a year in federal government operations.

In order to understand why carried interest is a capital gain, we should first examine what private equity does. Private equity is an industry of investors with management expertise and vision who form partnerships with pension funds, university endowments and charitable foundations to buy companies. It is the epitome of patient capital, investing in promising companies poised for growth and those in need of a turnaround.

The average private equity investment spans three to seven years. Companies owned by private equ! ity are located throughout the country, touching nearly every community. More than eight million people work at private equity-owned businesses based in the United States.

Private equity funds are a partnership between the firm, or general partner, and the investors, also known as limited partners. Partnerships are the oldest form of business.

In the case of private equity, the managers contribute their understanding of the companies to buy, operational expertise and, often, capital to the partnership. The limited partners - pensions, endowments and foundations - contribute just capital to the endeavor.

The partnership structure results in an alignment of interest between the private equity general partner and their investors to expand companies over the long term. Private equity firms are true owners in the companies they buy. Because they develop strategic business plans, sit on boards and work to strengthen the companies they own over many years, the income they receive is a capita gain.

The private equity firm is compensated with this alignment of interest in mind. Typically private equity investors are paid a 2 percent management fee, on which they pay ordinary income tax rates, and a 20 percent carried interest of the partnership’s profits that is only paid after limited partners receive a preferred return of 8 percent.

Carried interest, therefore, is the profits share on the sale of a capital asset and not “ordinary income” as some would have it treated. In other words, it is a capital gain within a partnership and is rightfully taxed at the long-term capital gains rate â€" provided that the asset, or company, is held for more than one year.

The aristocratic argument presented by Ms. de Rothschild and others that capital gains treatment should only be available to those with money to invest would advance a policy that puts a higher value on financial contributions than vision, hard work and other forms of “sweat equity.”

The underlying! principl! e is no different than two friends who partner together to purchase a restaurant. One might bring capital and the other brings expertise. The restaurant could be in disrepair or a great concept that needs additional capital to expand. The chef identifies the restaurant to buy and possesses the skills to manage the restaurant and add value to the enterprise over time. The friend has the capital to invest, but doesn’t possess the operational or investment skills to generate a return.

When they sell the restaurant years later, both partners receive capital gains treatment on their long-term investment. A private equity partnership works in the same way. This is Partnership Law 101.

The capital gains rate exists to provide incentive for investment partnerships to take risks, invest hundreds of billions of dollars of capital into new and existing businesses and contribute operational expertise to improve these businesses over time.

The Joint Committee on Taxation, a nonpartisan committe of Congress, has pegged the additional revenue from carried interest at just $16.85 billion over 10 years. The joint committee estimate even includes the controversial enterprise value provision, which experts believe constitutes two-thirds of the total revenue assumption.

Permanent tax increases on private equity, venture capital and real estate in exchange for a short-term spending patch does not come close to solving our country’s fiscal situation. Policy makers should reject calls to eliminate this incentive for long-term economic growth in exchange for 3.1 hours of federal government operations.