Carry Interest Tax Break – A Revision

What changed my mind about the carry tax legislation.

A few months ago I wrote a blog post about the recently introduced bill poised to tax the carry interest at the ordinary tax rate (35-40%) instead of the capital gains tax rate (15%). The U.S. House of Representatives just passed the bill to the Senate with language that will subject 75% of the carried interest to normal income tax rate and the remaining 25% carried interest at the capital gains tax rate. 
Back when the bill was introduced in the House, I blogged about it and expressed my disapproval of the idea for higher taxation. Six months later, I find myself sitting on the other side of the fence.

When I wrote that post, I defended the venture capital tax break. I did so because I viewed it as an incentive for venture capital firms (VCs) to provide venture funding to new, promising businesses, and thus spur innovation and support the economy. I now realize that in December I was missing a vital point –- the VCs are not the investors but managers of the invested funds.

In fact the money in a venture capital fund is provided by the Limited Partners — pension funds, endowments, insurance companies, and wealthy individuals. Those investors are and should be taxed at a lower capital gains tax rate. At the same time the VCs manage the money for which they receive an annual percentage fee of the fund’s value (about 2%) and carry interest (usually 20% of the fund return) at the end of the fund’s life.

With this in mind, the legislation does make sense. In essence the tax on the carry interest should not differ from the tax on ordinary income as the carry interest, in reality, is a management fee paid to VCs for the service they provide to their LPs. It will be interesting to see what the final shape and form of the new legislation will take.