A current debate among Congressional policymakers and members of the private equity industry centers on how to tax the profits, or carried interest, earned by private equity managers.  To provide some background, private equity managers earn two types of compensation: a fixed management fee tied to a percentage of the assets under management and carried interest, or "carry" as it is commonly referred to, which represents a portion, generally 20%, of the profits generated by investments.  Since most profits for private equity managers arise from long-term capital gain realizations, carry is primarily taxed at the long-term capital gains rate of 15%, as opposed to being taxed at the ordinary income rate, which is generally 35%.  This differential in tax rates, to some policymakers, results in substantial foregone tax revenues.

Spearheading the effort to enact legislation that increases taxation on carry to ordinary income rates are Senators Charles Grassley and Max Baucus of the Senate Finance Committee.  They proposed legislation in June that has spurred several congressional hearings and heated discourse amongst top private equity industry executives and policymakers from both parties.  As a form of compromise, some policymakers and members of the private equity community have suggested raising the tax rate on carry above 15%, but not to the 35% level.

As the Director of the Congressional Budget Office ("CBO") describes it, the fundamental issue "is whether the general partner's carried interest should be treated as a simple investment by the general partner (albeit one that has no claim to the current capital of the fund but only to the future appreciation thereof), or whether, at least to some degree, the carried interest in substance is a form of compensation paid by the limited partners to the general partner for services in managing the fund."[1]

To date, arguments levied against the favorable capital gains tax treatment are based on the theory that the intellectual capital contributed by the general partner outweighs their financial contribution.  That is, carried interest should not be principally considered a return to the general partner for undertaking financial risk, but rather deferred compensation that is a function of performance.

Recently, arguments in favor of keeping the capital gains tax treatment in place have focused on the "unintended consequences"[2] to the financial system and the broader economy should a disincentive be placed on raising private equity funds.  As noted in a recent article on carried interest in The Wall Street Journal, "among other things, lawmakers worry a tax boost could take a bite out of public pensions' investment returns, adversely affect financial-sector profits and employment or, more broadly, disrupt investment incentives."[3]  The impact on public pension plans could come in the form of higher management fees to compensate for the increase in taxes.