Carried interest is the share of net profits generated by a business, representing the contributions of intellectual and sweat equity of a partner to the business enterprise.
For more than fifty years, the U.S. Internal Revenue Code (the Code) has permitted partners in investment partnerships to pool the capital of investors with the skills of entrepreneurs in joint profit-making enterprises. To align interests and contributions to the partnership, the Code treats a partner’s “carried interest” in the profits on the same terms as the other partners.
Most hedge fund income is currently taxed at ordinary income rates, rather than as capital gains because funds generally invest in capital assets (such as stocks and securities) and hold them for less than one year, designating them as a short-term capital gain for tax purposes. Changing the character of all carried interest income (both assets held long-term and short-term) to ordinary income would create significant collateral effects (e.g., adverse effects on state and local tax laws). Further, many hedge funds elect to be treated as a “trader” under the Code, and as a result, their investments are treated on a marked-to-market basis and taxed at ordinary income rates.
President Obama’s Budget Proposal for Fiscal Years 2011 and 2012 included a proposal that would make carried interest taxable as ordinary income. The U.S. House of Representatives and U.S. Senate have also considered, and passed, a number of bills in recent years that included provisions to tax carried interest, or a portion of the interest, as ordinary income. To date, the House and Senate have not agreed on a unified approach to this issue and as a result, legislation taxing carried interest as ordinary income has been not been signed into law.
What is Enterprise Value?
Any individual, partnership, or corporation in the U.S. that creates a business and develops a sustainable customer list and an identifiable brand will have created goodwill or enterprise value. When that person sells the business, any gain attributable to the enterprise value of the business is taxable at capital gain rates. If the business is operated in a partnership or a corporation, gain from the sale of the partnership interest or the stock will also be taxes at capital gain rates to the extent attributable to goodwill value.
Legislation considered in the 110th and 111th Congress to change the tax treatment of carried interest would have required the owners of certain investment services businesses to pay tax at ordinary income rates on at least a portion of the gain from the sale of enterprise value.