New Way to Tax Carried Interest Income?

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By Aaron E. Lorenzo and Kaustuv Basu

Oct. 6 — Carried interest income should get taxed differently for investors and fund managers, said a paper released by the Urban Institute.

For managers, carried interest should be treated as labor income, but it should be deductible against ordinary income for investors, said Donald Marron, the Urban Institute’s director of economic policy initiatives who authored the paper, which was released Oct. 6.

Directing the tax benefits to fund investors makes sense because they—and not the managers—invest in businesses, bear financial risk and provide any sweat equity, Marron said. Managers can still benefit from the lower tax rates on capital income to the extent they invest in their funds, he said.

That marks an improvement from the current practice of giving all carried interest preferential tax treatment, which Marron said taxes the income too little. At the same time, he said changing the present treatment to labor compensation and taxing it at rates of up to 44 percent would go too far.

Carried interest refers to certain profits earned by fund managers and other investors. Democratic lawmakers have complained for years about taxing carried interest at preferential rates and have looked for avenues to tax the income at ordinary rates, while presidential candidates Hillary Clinton and Donald Trump have said that they want to end the tax break.

Positive Compromise

Some early reviews of Marron’s suggestion were positive.

“In terms of purity of tax policy, this seems like a sensible solution,” said Marc Goldwein, senior vice president for the Committee for a Responsible Federal Budget.

But making a change like that proposed by Marron would still leave inequalities in other parts of the U.S. tax code, Goldwein said.

Still, he praised the proposal as a positive step toward more tax fairness and better tax efficiency, though it wouldn’t have major budget implications, probably not generating more than $1 billion a year in new tax revenue, he said.

Scott Greenberg, an analyst at the Tax Foundation, said the study made a compelling case.

“Overall, the Tax Policy Center report takes a sensible middle ground between the investment funds and the progressive policymakers, the former of which advocate for the status quo, and the latter of which argue that all carried interest should be taxed at ordinary income rates,” Greenberg said.

Marron proposes that all investment income earned by taxable investors would be subject to the lower capital gains rate, whether paid out as carried interest or not, he said. “This means that all income in taxable accounts would be subject to rates up to 44 percent when originally earned as wages, and would only be taxed at rates up to 25 percent when realized as gains,” Greenberg said.

Fund managers would pay ordinary income tax rates on carried interest compensation, while fund investors would be able to deduct carried interest from their ordinary income, Greenberg said. “The two effects would cancel out, resulting in no higher tax on the underlying investment income than on investment income in any other taxable account,” he said.

This could address the public outcry over hedge fund and private equity managers paying lower rates on the majority of their income, Greenberg said.

Taxed Appropriately

Not everyone shared that view.

James Maloney, a spokesman for the American Investment Council, a lobbying group for hedge fund and private equity managers, said that carried interest is appropriately taxed as long-term capital gains.

“As a profit share in a capital asset—an operating business—owned for years, carried interest in the context of private equity bears with it the risk that the business will not generate a profit. Thus, there should be no alteration to the tax treatment or classification of carried interest,” Maloney said in an e-mail when asked about the study.

He added that changing the tax treatment would disrupt a long-standing policy that rewards risk-taking entrepreneurs.

To contact the reporters on this story: Aaron E. Lorenzo in Washington at and Kaustuv Basu in Washington at

To contact the editor responsible for this story: Meg Shreve at

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