Carry is strange

A new tax idea from two US lawmakers gets one step closer to recognising the true nature of carried interest.

We’ve all heard the arguments for and against carried interest being treated as ordinary income. But one thing we’ll never hear is a brief, simple argument on this topic.

Partisans on each side of the issue are forced to take a deep breath and describe elaborate plumbing systems that result in cash flowing to either the higher tax bracket or the lower one.

The arguments for and against are complex because carried interest is neither a common nor straightforward form of payment. It does not fit neatly into either the capital gains category or the ordinary income category, no matter how much rhetorical force is put behind attempts to do so.

Today’s hybrid tax proposal from US Senator Max Baucus and US Representative Sander Levin is a remarkable next step in this debate because it – inadvertently – acknowledges the strange hybrid nature of carried interest.

The proposal would tax 75 percent of a GP’s carried interest take-home as ordinary income, while the remaining 25 percent would get the lower capital gains rate.

David Snow

The suggested compromise is certainly better for GPs than the original “it’s-all-income” idea, but it exposes as disingenuous those lawmakers who argue that GPs currently enjoy a blatant loophole that converts ordinary income into capital gains. If this argument is credible, why the compromise? Should greedy GPs be allowed to enjoy an unfair loophole on 25 percent of this supposedly ordinary income?

One has to assume that Congress is more concerned with raising revenue than with intellectual arguments about the proper tax treatment of carry. And yet the compromise does end up a little closer to recognising what carry is, which is sort of income and sort of capital gains.

Carry is a capital gain because it is derived from investment proceeds and then later distributed among partners however they see fit. It is ordinary income because it recognises the service that the GP has provided in order to earn a disproportionate share of the profits. It is a capital gain because its payment to the GP depends entirely on the success of investments. It is ordinary income because the GP is paid from capital that others put at risk. No tax code was designed with carry in mind because very few people in the world earn it.

If this bill passes, the old either/or debate will cease in the US and a new debate will commence – to what extent is carried interest ordinary income? 75 percent? 50 percent? 25 percent? Clearly this is a conversation that skeptics of carry are more willing to entertain.