Taxation of Carried Interest

By: Robert D. Starin, K&L Gates LLP.

The tax treatment of carried interest has for many years been a high-profile target for potential reform. “Carried interest” refers to the share of profits or gains from investment received by a manager of a private equity fund, hedge fund, or similar investment vehicle, which is typically unrelated to any capital investment by the manager.

UNDER EXISTING LAW APPLICABLE TO ENTITIES TREATED as partnerships for U.S. income tax purposes, carried interest is generally taxed at favorable long-term capital gain rates. Many lawmakers view this treatment as inequitable, under the premise that long-term capital gains should apply to returns from the investment of capital, rather than receipts for the provision of services. In the private equity world, proposed legislation to close the carried interest “loophole” could have a profound impact on the economics and structure of investment funds and their portfolio companies. This article addresses the U.S. federal income tax treatment of carried interest paid to private equity fund managers, as well as potential changes in the law that could impact this treatment.

Economics of Carried Interest

Carried interest is designed to reward fund managers for identifying and managing investments. While fund managers receive a fixed management fee, the bulk of their profits is typically derived from carried interest that is contingent on the success of the underlying investments. Private equity funds are generally structured as limited partnerships, with the capital investors holding limited partner interests and the manager setting up a special purpose vehicle as the general partner. Because of the beneficial tax treatment described in more detail below, fund managers’ “carry” is structured as a special class of equity in the underlying investment partnership rather than a contingent success-based fee.

There are two primary methodologies for calculating carried interest: net profits and gross profits. Under the more common net profits methodology, carried interest is calculated as a percentage (usually 20%) of the profits generated from the fund’s investments less expenses, which typically include management fees and other overhead expenses that are not capitalized into the costs of investments.

To read the full practice note in Lexis Practice Advisor, follow this link.

Robert D. Starin is a partner at K&L Gates LLP. Mr. Starin’s practice emphasizes federal, state, and international tax issues and general corporate issues for both foreign and domestic clients. He has worked on numerous transactions involving mergers and acquisitions (U.S. domestic and cross-border), divestitures, complex joint ventures, and inbound and outbound investments. He advises public and private corporations, limited liability companies and partnerships on various tax matters, including choice of entity, structuring of international operations, and executive compensation issues.

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