Dispelling the Mystery of the Carried Interest Monster

I have been asked recently… What is carried interest and what’s all the hoopla about?

First, what is carried interest?  In the financial service industry, carried interest refers to the share of profits that the manager of a private equity or hedge funds receives.  Typically this performance fee or carried interest is 20% of a fund’s profits.   The tax treatment of this carried interest has been debated for years and took a front seat when presidential candidate Mitt Romney released his personal income tax return.  His return showed that most of his income came from carried interest and was taxed at the favorable long term tax rate of 15%.

Now, let’s take a step back and understand how private equity and hedge funds operate.  A fund manager, usually a partnership, will raise funds from private investors while putting in very little of its own money.  The manager will get paid a management fee which is typically 2% of net assets in the fund.  It will also receive a 20% performance fee. This performance fee or carried interest is based on the profits of the fund.  Thus, a fund that has $100 million under management and earns $10 million in profits in year one, will pay the manager a management fee of $2 million (2% of the $100 million) which is taxed at ordinary income tax rates.  The manager will also receive carried interest of $2 million (20% of $10 million in profits).  The carried interest, depending on who you believe, is taxed at the favorable long term capital gains rate of 15%.

I say “depending on who you believe” because this isn’t exactly the truth.  Private equity and hedge funds earn different types of income:  interest income, dividend income, short term capital gains and long term capital gains.  The 20% carried interest that is earned by the manager keeps the same attributes as it was earned by the fund. That is, in our example above, if the $10 million in profits was all from interest income, then the carried interest would be taxed to the manager as interest income which is taxed at ordinary tax rates and NOT the favorable long term capital gains rates.

Well, that was easy, but unfortunately not the end of this mystery.  Carried interest that represents long term capital gains means the fund generated income by investing in businesses for more than one year and then sold that business for a profit.  The debate right now is whether the manager should receive that capital gain treatment, when for the most part the money used to generate that capital gain belongs to the limited partners who put up the bulk of the money.  And you know what Frank and to the Point says about that? Read the blog Double Taxation by my partner Anthony Nitti.  After all, he is the tax guy around here and has no problem speaking his mind on these touchy topics.

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