The taxation of carried interest became one of the hottest issues on Capitol Hill in 2007, as private equity’s heightened profile drew the attention of US lawmakers looking to offset revenue declines from the expected repeal of an outdated tax act called Alternative Minimum Tax (AMT).
Sister publication PEI Manager asked two tax experts with opposing views to discuss what’s been so controversial on the Hill: Should carried interest maintain its current designation as capital gains, a 15 percent rate, or be taxed as ordinary income, a rate as high as 35 percent?
A lively debate was had between Mary Kuusisto, a tax partner at the law firm Proskauer Rose, and Darryll Jones, a professor of law at Stetson University in St. Petersburg, FL who suggested that carried interest is to the tax code “what Abu Ghraib was to the Iraq war”, during his testimony at the Senate Finance Committee’s second hearing on carried interest in July 2007.
The conversation started the way formal debates start – with a resolution. In this case the resolution was: “Resolved: The status quo should be maintained with regard to the taxation of carried interest.” Kuusisto supports the status quo, while Jones argues for a change.
What follows is an excerpt from the larger feature that appears in the January issue of the magazine.
Mary Kuusisto, (MK): Here’s a baseline question – is it your view or proposal that in order to be fair and equitable there should be no preferential capital gain treatment for any type of equity compensation, whether in partnership or corporate form?
Darryll Jones: Yes. I think that’s a fair summation. What we’re talking about is the discrimination essentially between lower-paid laborers and higher-paid laborers. We’re talking about service income. The reason why I think venture capital or private equity or hedge fund managers are being singled out is simply the notoriety that’s been generated around this particular industry. I agree that they shouldn’t be singled out. But the fact that they shouldn’t be singled out is neither here nor there with respect to whether they’re being treated fairly vis-à-vis other laborers in the first place.
MK: Certainly, the folks in the investment fund world view equity compensation as a very, very powerful tool in order to allow businesses to grow in the United States. The venture capital industry views it as a way to get talented people to form start-up companies and to allow smart, intelligent people to forego more lucrative jobs. Instead of being paid very high salaries, the founders and employees agree to take equity in the companies they form with the hope they’ll be built up into valuable businesses. One measure, in a mix of measures, of encouraging them to do that – to take that risk – is by permitting them to get a lower tax rate upon the sale of that business. The idea is that the amount of risk that they’re taking in putting their energies – which they could have been put into a different kind of service – into a business which could be a valuable part of the US economy is something that should be rewarded.
The idea is that certain types of human capital should get the same preference as financial capital, even though it hasn’t been previously taxed. And that is okay because a lot what people might consider to be “previously taxed” financial capital often is not, once you look and see who the taxable unit is. There’ve been a lot of folks who have been able to invest “previously taxed” financial capital on a tax-advantaged basis, but it was perhaps their parents or grandparents who were taxed on that income, or maybe that income was never taxed. So the previously taxed argument might go a little too far as well.
If you’d like to read the rest of the debate, click here for details on how to become a subscriber to PEI Manager, the leading journal for the finance, operations and legal professionals in private equity.