Memo to Congress: There are Legal Issues With Taxing Carried Interest as Ordinary Income


The carried interest debate has kicked into high gear, with legislation currently under consideration that could tax carried interest as ordinary income. Much of the conversation relates to the incentives or disincentives this would create or whether it is advisable. On that front alone, our view is that it’s a bad idea. Risk takers and investors should be rewarded for creating value, and that behavior should be encouraged as much as possible.

While treating carried interest as ordinary income may not kill the whole venture capital industry, it will cause some degree of contraction. Basic economics will tell you that some number of skilled people with other investment or career options will choose alternatives such as investing in the public markets over private equity if the disparity in tax treatment tips the scales for them.

The tougher issue to resolve is the legal analysis of how this income should be characterized. The “capital gains” argument is essentially that carried interest relates to the split of the fund’s capital gains and should be treated that way. The “ordinary income” argument is that carried interest is really a salary formula for the fund’s managers based on the fund’s performance and should be characterized as compensation. Our view is that carried interest should be treated as capital gains. Here’s why:

In a simple example, if a company or individual invests $100 and receives back $1000, most people would agree that the $900 gain is a capital gain. Now admittedly, if the company uses $100 of that $900 to pay salaries, the salaries would be ordinary compensation income to the individual recipients. But that isn’t the most accurate portrayal of what happens with a VC fund. The carried interest does not go to individuals as a performance bonus. It doesn’t immediately go to the individuals at all. Rather, it is just an agreed upon split among partners of the partnership’s gains. Partnerships are allowed to do this.

The biggest problem from a legal analysis with this proposed legislation is how we would reconcile this with the way the tax laws treat other pass-through entities such as limited liability companies and non-VC/PE partnerships. If carried interest is deemed to be ordinary income because one of the partners gets a disproportionate share of the upside by contract, what will we do with other partnerships that do the same thing?

For instance, if Bob and Tom form an LLC with the agreement that Bob will get some form of economic preferences or privileges (which happens all the time), will Congress want to treat any of the company’s capital gains that flow through as ordinary income to the extent they exceed Bob’s pro rata portion of the amount invested?

If the answer is yes, this will often create a strong and irrational disincentive to investing through an entity because the aggregate tax bill for Bob and Tom is suddenly higher for no apparent reason. Such a scheme is also counter to the generally accepted principle that the investment characterization of a pass-through entity’s income should generally flow through to the owners without regard to preferences or privileges some owners may have over others.

If the answer to this question is no (that Congress does not want Bob and Tom to have any of this hypothetical income treated as ordinary income as a result of Bob’s preferences), you have to question how it would be constitutional to tax VC and PE funds differently than other pass-through entities that effectively have the same legal form and the same or similar allocation and distribution schemes. This feels a lot like arbitrarily having different tax rates for identically situated entities, which you can’t do.

If this legislation passes, I would hope and expect that it would get challenged in court.

Paul Koenig is an attorney and co-founder/managing director of Shareholder Representative Services (www.shareholderrep.com), which serves as a professional shareholder representative following the acquisition of a VC-backed portfolio company.

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