Understanding Carried Interest: Its Taxation and Implications
Carried interest has been a contentious issue in the financial world for decades, with its origins tracing back to maritime trade practices where ship captains received a percentage of goods as compensation for their efforts in ensuring the safe transport of cargo.
Historical Context and Terminology
The term "carried interest" originally referred to the practice of giving a ship captain an interest in the cargo being shipped as an incentive to protect it. The idea was that the captain would earn a percentage of the cargo if the ship arrived safely. This type of arrangement was common for portcullises like spices.
As an experienced professional in the financial sector, with a PhD in Finance from UC Berkeley and experience in Fixed Income Research on Wall Street, I have never encountered the term 'carried interest.' It is more commonly referred to as accrued interest.
Taxation of Carried Interest
The taxation of carried interest has been a significant concern since the mid-2000s, especially with the vast compensation earned by certain investors in the private equity and hedge fund sectors. Historically, carried interest has been treated as a capital gain for tax purposes in most geographies, primarily due to the substantial commitment of capital by the fund manager.
Carried interest employs a tax-advantaged method of compensating investment managers by structuring their income as capital gains income, which is taxed at a maximum rate of 20%, rather than ordinary income income taxed at a maximum rate of 39.6%. This tax advantage creates a significant incentive to categorize income as "capital" instead of "ordinary."
Legal and Tax Framework
Section 1 of the Internal Revenue Code (IRC) imposes a tax on every citizen and resident of the United States. Section 61 defines gross income very broadly as "all income from whatever source derived," encompassing various types of income such as compensation for services and gains derived from dealings in property.
However, under § 1h, the tax rate is 20% for capital gains income. A capital gain is recognized when a capital asset is sold. § 1221 defines a capital asset as "property held by the taxpayer," which includes almost every asset owned for personal or investment purposes, such as stocks, bonds, personal residences, household furnishings, and automobiles.
Typically, the distinction between ordinary income (income from work) and capital gains income (income derived from selling a capital asset) is clear. However, there is an exception: the managerial labor exerted on a capital asset is often taxed at capital gains rates, not ordinary income rates. For example, if an individual buys a property, improves it, and sells it for a profit, the profit is taxed as capital gains, despite the labor investment.
Carried Interest and Tax Policies
Carried interest benefits from this exception, allowing fund managers to receive their earnings in the form of capital gains rather than ordinary income. This treatment of carried interest has been a subject of discussion and debate in the financial and political spheres, with differing opinions on its fairness and tax policy implications.
In summary, carried interest is a structured form of investment compensation that leverages the tax advantages of capital gains to reduce the overall tax burden on investment managers. Its treatment under tax law and its impact on fundamental principles of taxation make it a complex and contentious issue in the financial world.