Two and Twenty Revisited: Taxing Carried Interest as Ordinary Income Through Executive Action Instead of Legislation

Abstract

The Treasury Department should issue regulations treating the allocation and distribution of partnership profits in private equity funds — carried interest — as payments for services. My suggested “tax arbitrage” approach uses the presence of tax-exempt limited partners in the investment fund as a proxy for arrangements that inappropriately exploit the difference in tax rates among partners to reduce overall tax liability. The end result of treating carried interest as a payment for services achieves a result similar to the policy recommendation of Two and Twenty: Taxing Partnership Profits in Private Equity Funds, 83 NYU L. Rev. 1 (2008), but it would do so through executive action and without the need for new legislation.

A tax arbitrage approach fits seamlessly into the fabric of partnership tax policy. Subchapter K often depends on the adverse interests of partners to guard against abusive tax planning. When adverse interests are not present, special rules often apply. In the case of investment funds, the presence of tax-exempt limited partners is a good proxy for tax arbitrage because an allocation of capital gains to the general partner in lieu of an explicit payment for services is not costly to tax-exempt or tax-indifferent partners, who value the foregone tax deductions at zero.

Changing the tax treatment of carried interest by regulation is an appropriate exercise of the delegated legislative authority granted in § 707(a)(2)(A). While new regulations proposed in July 2015 focus almost exclusively on entrepreneurial risk, a close reading of the legislative history from 1984 shows that Congress expected that the managers of an arrangement like a modern private equity fund would be taxed at ordinary rates.

Keywords: tax, public choice, partnership, private equity, hedge funds, carried interest