The Carried Interest Debates – To Tax or Not to Tax, and What Accounting Path to Follow

Carried interest has been a heated issue for a number of years, within industry and political circles alike. But it’s the 2016 presidential election that has moved this accounting practice to the front burner. There aren’t too many issues on which the three remaining major-party candidates all agree, but opposition to carried interest is one of them. What is it about this much-maligned practice that has so many people choosing sides?

By definition, carried interest is “a share of any profits that the general partners (GPs) of private equity and hedge funds receive as compensation” for management responsibilities outside of the return they might receive as investors in that fund. For most funds, 20% of any profits are typically awarded to the GPs, with the remaining 80% going to the limited partners (LPs). This particular method of compensation, currently taxed at a capital gains rate of up to 23.8%, is designed to motivate fund managers, driving them to improve the performance of the fund.

This type of compensation gets its name from its cash flow characteristics. According to the Congressional Research Service, the 20% performance fee can be paid in cash or credited to the manager’s account. Since this amount is typically carried over from one year to the next until a cash payment is made, generally following the closing out of an investment, it is referred to as “carried interest.”

The Different Perspectives

Some within the industry believe that carried interest should be taxed on par with wage and salary income (ordinary income), subject to a top rate of 43.4%, and more in line with performance-based compensation such as bonuses. On the other hand, there are those who hold that GPs are akin to entrepreneurs starting a new business, and as such, should be rewarded for undertaking riskier projects. The latter argue against taxing carried interest at the higher rate, concerned that this will deter investment in riskier projects, ultimately stifling innovation and growth.

In Washington D.C., carried interest has been subjected to increased legislative scrutiny after President Obama’s 2008 and 2012 campaign platforms both included proposals to tax this compensation as ordinary income. The Treasury Department estimated the proposal would raise $17.7 billion over a decade as fund managers would be subject to a higher tax rate for carried interest. These measures, however, have failed to gain traction on Capitol Hill. In May 2015, Rep. Paul Ryan, then chairman of the House Ways and Means Committee, pushed carried interest off the legislative agenda until 2017.

As a result of the stalemate in Washington D.C., state legislators have taken up the issue. Earlier this year, New York State Sen. Jeff Klein (D-Bronx/Westchester) introduced a bill aimed at ending the carried interest “tax break commonly” used by private equity and hedge fund managers. While state legislators can't change the federal tax code, this bill would create a 19% “carried interest fairness fee” on GPs’ income from investment management services. In effect, it would raise taxes paid on fund managers’ profits to offset the lower capital gains tax rate applied on carried interest. Revenues would be paid to the State of New York, and according to Sen. Klein, would result in further $3.7 billion in additional tax payments each year.

Outside of New York, there are parallel efforts underway at the state level in nearby Connecticut, New Jersey and Massachusetts. There are similar efforts underway in Wisconsin.

Presidential Election Attention

Meanwhile, the issue has also gained considerable attention in the ongoing race for the White House, with leading candidates from both parties – including Hillary Clinton, Donald Trump and Bernie Sanders – all promising to reform the practice. All three candidates share a common view on this matter, vowing to scrap this preferential treatment for fund managers should they be elected. Regardless of who inhabits the Oval Office come this November, it will be an uphill battle for any of the presidential candidates. Current efforts, such as the Carried Interest Fairness Act of 2015, have gained little traction in the House.

Taxation and Accounting Standards – Contradictory Views

However, according to Robert Crnkovich, senior counsel in the Treasury Office of Tax Policy, tax officials are preparing to be able to respond quickly with carried interest guidance should Congress pass legislation on the matter in the post-election season.

Another emerging undercurrent within the asset management industry relating to carried interest are the contradictory views on how and when it will need to be reported based on forthcoming rules, which are set to come into play in 2018. Groups such as the Securities Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) have yet to converge on how carried interest should be treated under the new rules, which could have significant impact on private equity funds’ revenue reporting in quarterly earnings statements.

The coming years are likely to bring carried interest guidance to the forefront, whether it relates to its taxation or its role in forthcoming accounting standards.