One the main reasons I set up this blog is to try to do my little part to clear up misperceptions about taxes spawned by mainstream reporting on the topic. To paraphrase Lady Thatcher, the facts of taxes are conservative. If conservatives could do more to inform people about the reality of taxation, support for conservative tax positions would grow.
One topic that generates more than its fair share of confusion is the taxation of “carried interest.” The Wall Street Journal’s main editorial on January 26, 2012 (“Romney’s Fair Share”) referred to carried interest as “the accounting term for revenue in general partnerships – private equity and hedge funds yes, but also certain real estate and oil-and-gas outfits and others.”
Good Lord, where to begin? No, no, no. A carried interest is a disproportionate allocation of profits to a general partner of an investment partnership (i.e., its interest is “carried” by the limited partners) to compensate the general partner for managing the partnership.
It is in no way an accounting term for revenue. And no investment partnerships are structured as general partnerships – they are either limited partnerships or limited liability companies. Finally, the term carried interest has nothing to do with private equity or hedge funds specifically; it applies to all investment partnerships, including venture capital, real estate, natural resources, LBO funds, etc.
The Journal article on page A6 from the same day (“Romney Rethinks Key Income-Tax Break”) did a much better job. Unfortunately though — like much mainstream reporting on the topic — it perpetuated the misconception that carried interest treatment somehow transmutes ordinary income into some sort of magical, rich-guy income that is taxed at 15%. It does no such thing.
Profits that are allocated to a general partner through a carried interest retain their character as either ordinary income or capital gains. If the partnership has realized ordinary income or short-term capital gains, then the general partner pays tax at ordinary income tax rates. If the partnership has realized long-term capital gains, the general partner pays tax at the 15% rate.
I am sure someone at the Journal knows all of this; it would be nice if he or she could pitch in with the writing from time to time.