The Tax Advantage to Paying Private Equity Fund Managers with Profit Shares: What is it? Why is it Bad?

Abstract

Private equity is very much in the public eye. The prototypical private equity fund purchases, restructures, and resells ailing companies. The managers of such funds are typically paid with a share of the fund's profits. Over the last several months, the favorable income tax treatment of these compensatory profits interests has been the subject of an ever swelling stream of headlines, editorials, and Congressional hearings. But despite the attention the issue has received, the tax advantage of compensatory profit shares is not well understood, and the reasons for reform are, accordingly, not well developed. This article clarifies the nature of the tax advantage and, with that understanding in mind, critically assesses some of the chief arguments for and against the current tax treatment.

The appendices for this paper are available at the following URL: http://ssrn.com/abstract=2017126

Keywords: Carried interest, private equity, profits interests, carry, capital gains, ordinary income, inputed income, deferral

JEL Classification: H2, H25, D2, D3, D6