The Real Problem with Carried Interests

The recent proposals to reform the tax treatment of private equity, venture capital, and hedge fund managers are misguided. Policymakers and commentators often take industry-focused, results-oriented approaches to the “carried interest” debate, thereby obscuring the real source of the policy objection to carried interests. Instead of starting with a result that is objectionable and trying to find a way to change the law to avoid the objectionable result, this Article begins with the law and facts relevant to carried interests and systematically unpacks the tax rules that combine to produce the current tax treatment of carried interests. As a consequence, this Article provides structure to the voluminous discourse about carried interests, identifies the key features of the tax law that are most likely to cause hostility toward carried interests, and analyzes how to design reform proposals that are most responsive to each objection. More generally, this Article redirects attention away from the narrow carried interest issue and toward the more fundamental aspects of the tax system that need reform.Ultimately, the appropriate response to the carried interest controversy (assuming a response is warranted) depends on whether the crux of the problem is the use of equity compensation, one or more technical aspects of the partnership tax rules, revenue needs, distributive justice considerations, disapproval of the fund industry, or something else entirely. But the recent legislative proposals fail to respond effectively to any of these issues, and should be therefore abandoned. Instead, policymakers should uncover and fix their fundamental problem with carried interests