July 30, 2014

The Carried Interest Advantage: Will It Last?

The top 25 hedge fund managers earned $14.4 billion in 2012, while an estimate of the earnings of private equity managers was $45 billion for the past six years. Currently, fund managers enjoy substantial tax benefits due to their ability to treat their performance bonuses as capital gains and defer the payout from year to year — a concept called “carried interest.”

Fund structure

Private equity funds and hedge funds are alike, because they are structured as partnerships that funnel taxable income or loss to the partners and confer the ability to configure tax attributes. The general partners are the fund managers who steer investment and managerial decisions. The limited partners are investors, who provide most of the capital but have no say in the management of the fund. Limited partners are generally large institutional investors, such as pension funds or insurance companies.

Taxable income sources

General and limited partners receive income proportionate to their shares when the fund’s investments increase. This income is taxed as a capital gain to the individual partners. Additionally, limited partners compensate fund managers with an annual management fee of two percent of the fund assets, which is paid as cash and taxed as ordinary income, as well as a performance bonus of 20 percent of the profits. This fee can be paid in cash or carried from year to year as a credit on the manager’s account, until paid out — hence the term, “carried interest.”

Advantages of the current carried interest tax arrangement

When carried interest is realized, it is taxed at the 20 percent capital gains rate — a discount of more than 19 percent from the top rate chargeable against ordinary income. Additionally, taxes on carried interest, as on capital gains, are deferred until the income is realized. Moreover, the managers can receive the bonus in foreign-chartered fund shares, which provide additional tax deferral and other tax advantages. An Atlanta corporate lawyer can provide guidance in this area.

Carried interest carried forward

The Presidential budget proposal for fiscal year 2014 and the CUT Loopholes Act, S. 268 treat carried interest as a combination of capital gains and ordinary income. S. 268 would tax the enterprise value — derived primarily from goodwill — as a capital gain, and the remaining amounts as ordinary income. The budget proposal states that the Administration will work with Congress to arrive at an appropriate enterprise value for the purpose of capital gains taxation.

In addition to legal expertise, the attorneys at Hartman Simons and Wood LLP bring business acumen garnered from their extensive experiences in the business world, and provide sophisticated advice in all areas of finance and corporate governance.

Connect with us and experience the difference