The debate over the taxation of “carried interest” has been percolating for years and the release of Mitt Romney’s personal tax returns in connection  with his presidential campaign  generated more wide-spread interest in the subject.  And while the relatively preferential tax rates that fund managers pay on these investment profits survived the “fiscal cliff” budget deal at the beginning of 2013, interest in this topic is as strong as ever.

What is Carried Interest?

             Carried interest, or “carry” as it is commonly called, is a right that entitles the general partner (“GP”) of a private investment fund to a share of the fund’s profits in exchange for managing the fund’s investments.  The GP, made up of individual investment professionals, contributes a relatively small amount of capital to the fund but takes on the role of managing the fund’s underlying investments.  In return, the GP typically receives an annual management fee equal to 2% of the fund’s assets, and a carry equal to 20% of the fund’s profits in excess of a specified return hurdle.  Because the GP is usually itself a flow-through entity for income tax purposes, the individual investment managers report and pay income tax on these amounts.

What is at stake?

             Under current law, the management fee is taxed like wages, subject to payroll taxes and  potentially higher, ordinary income tax rates.  The carry, on the other hand, is taxed at capital gains rates as an investment profit, subject to lower capital-gains income tax rates.  Currently, the top rate on capital gains is 20%, with an additional 3.8% surtax on investment income of the highest earners, while the highest Federal income tax rate applicable to wages is equal to 39.6%.  Without even taking into account the impact of payroll taxes, a change in the taxation of carried interest from capital gains to ordinary income would result in a 66% increase in federal taxes due with respect to these amounts.

Those in favor, those against

             Critics of the current rates of tax on carry argue that this amount is effectively compensation for services and should, therefore, be taxed like any other wages.   Proponents of taxing carry at lower capital gains rates, however, argue that carry is simply a share of the profit in a long-term investment.  The amount, they say, is at risk and that risk should be rewarded accordingly.

Venture Capitalists may have a better argument than other types of GPs

            Some argue that venture capitalists have an even better argument than their buy-out firm counterparts for lower tax rates on their carry.  The typical buy-out firm invests in established yet struggling companies, or companies that need a capital infusion to break beyond their current level of success.  They seek to sell the improved company at a profit within a relatively short horizon.  Venture capital firms, on the other hand, put their money at risk when a Company is in a much earlier and less mature stage, where it may take years to a generate a profit on that investment.   This, they say, is the true definition of capital gains:   incentivizing the investor to make a risky bet in the hopes of a big payoff down the road.   Critics of reform point out that without this tax incentive, venture capitalists will be less likely to take chances on start-up ventures which, in turn, negatively impacts U.S. business development and the economy as a whole.

Outlook Uncertain   

            President Obama has vowed to continue to take up this issue in budget talks.  As a result, asset managers will need to take potential reform into account when evaluating new investments, incorporating this political variable into their financial models.   While venture capitalists are arguably well-practiced in building some degree of uncertainty into the equation, there is no formula for predicting the outcome of this debate.  Thus, they will be left to judge, as best they can, the wisdom of taking a chance on a start-up venture without knowing exactly what the toll to be paid at the exit ramp will be.