A “carried” interest is the interest in partnership profits a general partner receives from the investing partners for successfully managing the investment and taking on the entrepreneurial risk of the venture. Carried interest may be taxed as ordinary income or capital gain depending on the character of the income generated by the partnership. Legislation proposing to change the tax treatment of carried interest has been introduced in various forms since 2007.
Bills such as the Carried Interest Fairness Act (S. 781, H.R. 1735, 116th Cong.), sponsored by Sen. Tammy Baldwin (D-WI) and Rep. Bill Pascrell (D-NJ), would reverse decades of longstanding tax policy and result in a huge tax increase on countless Americans who use partnerships in businesses of all types and sizes. The bills would discourage individuals from pursuing their business vision, encourage debt rather than equity financing, tax sweat equity invested in businesses and slow economic growth. These results would be particularly harmful to the nearly 8 million partners in U.S. real estate partnerships.
Businesses, large or small, in all areas use partnerships as their business entity of choice and include some form of carried interest incentive. Entrepreneurial ventures generally entail taking on significant economic risk. This partnership structure allows entrepreneurs to match their expertise and risk assumption with a financial partner and align the parties’ economic interests so that entrepreneurial risk taking is viable. This partnership structure allows the parties considerable flexibility in how they share the returns from the partnership over the life of the partnership. The return-sharing ratio between the general and limited partners can, and often does, change several times throughout the life cycle of the partnership.
The real estate industry utilizes partnerships with carried interests on projects ranging from small property development to large multi-billion dollar investment funds. Real estate partnerships represent nearly 50 percent of the 3.7 million partnerships in the United States. Those real estate partnerships owned $5.9 trillion in assets, earned over $90 billion in net income, and recognized roughly $50 billion in long-term capital gain in 2015.
Real estate general partners put “sweat equity” into their business, fund the predevelopment costs, guarantee the construction budget and financing, and expose themselves to potential litigation over countless possibilities. They risk much. Their gain is never guaranteed. It is appropriately taxed today as capital gain.
In typical real estate partnerships, before a financial partner enters the picture, a developer typically spends 3-5 years and hundreds of thousands to millions of dollars in architectural, engineering, consulting and legal costs to bring land to a buildable state—through zoning, plans, studies, and approvals.
Given that the finance partners have the most actual capital at risk, they want such risk capital (plus an agreed rate of return) returned as quickly as possible. The partnership is ideal in facilitating this because the partners can agree to pay all partnership income (in a real estate deal typically rental income) to the finance partners until their capital contribution, plus the negotiated rate of return thereon, is repaid. Thereafter, the partners can agree to share partnership income in any combination of ways they want to reflect the economics of the deal. When (and only when) the partnership assets are sold, the carried interest kicks in as a capital gain, assuming agreed upon profit targets are met, and the proceeds are shared in accordance with that agreement. In a typical real estate transaction, it is in fact only on sale that the carried interest produces capital gain.
A carried interest is, first and foremost, an interest in the partnership. Its amount and timing depends on the success of the partnership venture. Because it is a long-term, risk–based investment, it is not paid contemporaneously, nor is it guaranteed. Regardless of paper profits that might exist throughout the course of the investment, actual profit only exists when the asset is sold.
Enactment of bills like the Carried Interest Fairness Act would represent the first time that the sweat equity of an entrepreneur who is building a business would be taxed as ordinary income. It would discourage risk taking that drives job creation and economic growth. In short, it would have profound unintended consequences for main streets of cities and towns all across our country.
Carried interest tax proposals would make it more expensive to build modern shopping centers, offices and apartments, especially in long neglected neighborhoods or on land with potential environmental contamination. As a consequence, significant higher-risk development simply will not happen.
Taxing all carried interests in partnerships as ordinary income would be a huge tax increase that would drive significant investment from the economy.
March 26, 2019
Roundtable Weighs in Regarding Carried Interest
Senior Vice President & Counsel