Perhaps some legislators object to the fact that partners don’t pay taxes immediately on receipt of a profits interest, but rather only after they get actual distributions, suggests Heather M. Field, the associate academic dean and business law chair at the University of California Hastings College of the Law, in her paper, “The Real Problem with Carried Interests.” Or maybe they object to taxing any income at the lower rate established for long-term capital gains.
Some legislators may be opposed, in principle, to the use of equity interests to compensate fund managers, writes Field. To be sure, sponsors and their limited partners often agree that carried interest helps to align their interests; putting aside often-generous management fees, the partners don’t get rich unless they make money for their investors.
But situations could arise where sponsor-LP interests get whacked out of alignment. Consider a fund where a few early deals go bad. The sponsor, seeing the prospect of enjoying a share of profits fade, might be tempted to take more risk on subsequent deals to try to get in the money on the carried interest. Surely the LPs have far more to lose than the sponsor from a swing-for-the-fences mentality, even if the sponsor has some skin in the game.
Field points out that such so-called ”agency problems” between owners and managers feature in many forms of equity compensation. So, if this were the main complaint, legislators shouldn’t take the narrow step of raising taxes just on carried interest. Rather, she writes, “the appropriate response would deal with all equity compensation, or would at least try to ferret out which forms of equity compensation are least effective for aligning manager and owner incentives.”
Similarly, legislators may worry about excessive risk-taking not because of the potential for harm to individual investors but to the financial system as a whole. “If carried interests create incentives for managers to take risks that impose externalities on the public, that could justify additional government intervention,” writes Field. “Such intervention could involve prohibiting the use of carried interests, capping the portion of manager compensation that can be paid in the form of carried interests, or otherwise regulating the use of carried interests.”
Whatever the real objection, Congress should formulate a policy or tax law to address it. “Misguided” is how Field described recent carried interest tax proposals from Senator Carl Levin, President Barack Obama and others because they don’t address either the rationale behind current tax law or “the real source” of objections to how carried interest is taxed.