Semantics Aside, Carried Interest Is Salary

Oct 18 2007 | 1:58pm ET

By Jonathan Shazar, Senior Reporter

The growing debate about “carried interest”—the profit share of hedge, private equity and venture capital fund managers, i.e., their performance or incentive fees—both in the United States and in Europe, has predictably degenerated into something closely resembling class warfare. The left screams at a perceived inequity in the tax system that gives (a very small number of) rich people a big break, while the right argues that any change at all in that system of tax breaks will stifle investment, entrepreneurship and creativity and eventually lead to socialism.

Alas, in this case, the huddled masses have a point. “Carried interest”—which currently is taxed at the 15% capital gains rate, rather than the higher earned income rate—is not “sweat equity.” It is unambiguously salary: money paid to a fund manager for doing his or her job, that is, taking an investor’s money and making it grow as much and as fast as he can. To argue otherwise is merely a battle over semantics.

The fact of the matter is, both management fee and performance or incentive fee income is earned income, earned in the performance of a set task undertaken on behalf of clients with an understanding as to how the fund manager will be compensated, both if he does a good job or not. It is no different than the money made by mutual fund managers—generally exclusively in the form of management fees. Capital gains are investment income, a profit from the sale of some asset or another. In spite of the vociferous protestations to the contrary, they are not one and the same.

The fund manager’s sweat equity is her contribution to the fund management firm for which she works, not to the fund itself, in which the manager generally has a relatively small personal stake—relatively small, that is, with respect to the overall size of the fund. And as more and more alternative investment managers go public, we see that sweat equity realized in a big way, in the hundreds of millions of dollars that the founders of the Blackstone Group enjoyed when they sold part of their firm this summer for $4.1 billion, and in the millions or billions hedge fund founders get when Wall Street buys a piece of their firm. It is the investor who is taking the risk, and we reward that investor with a capital gains tax rate. The fund manager’s risk is the same risk run by anyone managing a business, and fund managers deserve no special treatment over businessmen and women who have chosen other fields.

To be sure, insofar as fund managers are also investors in their funds—and many, if not most, are—the return they earn for themselves on their own investment is indeed “carried interest” and ought to be taxed as such. But that 20% of the profits earned by investing other peoples’ money? That’s earned income, and it should be treated in the same way that any other earned income. For example, Wall Street bankers only get a bonus when they do well, but that doesn’t make the bonus capital gains, it is still earned income and thus taxed as so.

The bill currently making its way through the U.S. House of Representatives, which would change the partnership laws regarding “carried interest,” is problematic. Any bill that seeks to remedy the patent unfairness of fund managers paying less than half of what they should on most of their income should take into account actual sweat equity: Carried interest, properly applied, is a good thing, and a boon to the economy. But the flaws of one bill do not make right this wrong: Performance fee income is earned income, not carried interest. The battle is not about semantics, but simple fairness.

Do you think carried interest should be taxed as income? Please let us know your views by commenting below.


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