Carlyle, Bain Capital, and the Tax Treatment of “The Carry”

By :: January 12th, 2012

The on-again, off-again battle over how to tax the compensation of private equity managers may be on again, thanks to the confluence of two seemingly unrelated events.

The first is the controversy over the role of Bain Capital, the investment partnership whose founders included Republican presidential hopeful Mitt Romney. The second is the disclosure by another firm, The Carlyle Group, of how its top executives are compensated.

Both have heightened the focus on what these outfits do and how they are taxed. Bain and Romney, of course, have come under withering criticism from Newt Gingrich and Rick Perry who allege the firm’s investment strategy has led to reams of pink slips at companies it acquired.

That story is much more complicated than Romney’s opponents suggest. Nonetheless, it has lots of people thinking about what private equity does.  

Also this week, Carlyle disclosed its executive compensation in some detail, providing a rare glimpse into how investment firm managers are paid. Combined with the Bain flap, it will surely reopen the five-year old debate over the special tax treatment these partnerships receive through a mechanism known as carried interest or, in short, “the carry.”

The carry allows general partners in investment deals to receive compensation in the form of tax-advantaged capital gains, which are taxed at 15 percent, rather than as salary, which would be taxed as ordinary income with a top rate of 35 percent. This happens because the managers are paid with a fee (up to 2 percent) plus 20 percent or more of their investor’s profits. Those profits are taxed as capital gains even though the general partners may have little or no money of their own at risk in the deal.

Carlyle’s disclosure opens a small window into how this works. In 2011, its three founders were each paid about $140 million. But they received just $275,000 in salary and another $3.5 million in the form of a bonus (also taxable at ordinary income rates). But each also got $134 million—or 96 percent of their compensation--from investment profits. Much came from the carry and is taxable at 15 percent.

It is difficult to know exactly how much of that compensation was performance-based and how much came from fees. But if all of it were taxed as capital gains, and assuming the partners pay at the top ordinary income rate of 35 percent, they’d each save $27 million.         

The story gets more complicated thanks to the reason why Carlyle disclosed the compensation of its founders. It did not do so, it is fair to say, with enthusiasm. But disclosure is the price the firm’s owners must pay to go public, which is their intention.

That raises the high-stakes question of how to tax the proceeds from the sale of a partnership interest in one of these firms.  This would apply where the entire partnership dissolves, as Carlyle soon will. It may also apply when an individual partner in a firm, such as Romney, cashes out. The New York Times reports that Romney continues to receive a share of investment profits from Bain, although he retired almost 13 years ago.

Should these profits be taxed as capital gains, ordinary income, or some of each? Legislation kicking around Capitol Hill takes the last approach, although different bills use different formulas. Carlyle may want to go public under current law to avoid what could well be a higher tax bill if Congress ever cracks down on the carry.      

This week’s news may make that more likely, especially since lawmakers are scrambling to find revenue to pay for efforts to extend both last year’s payroll tax cut and four dozen other expiring tax breaks. On the other hand, Congress has been trying for five years to address what seems to be an obvious inequity in the law and has gotten nowhere.


  1. Ralph H  ::  5:31 pm on January 12th, 2012:

    The capital gains for “Carry” never made any sense to me, particularly because the General Partners had little skin in the game. There are many other people who have performance based compensation, salesman, bond traders, bartenders, sports stars, and they all get taxed on (reported) compensation at ordinary rates.

    Individual company owners only get a capital gain on sale, not on their salary or bonus and often have their entire assetsw pledged as collateral on the3 investment; much more than the investment partnerships.

  2. Vivian Darkbloom  ::  3:50 am on January 13th, 2012:

    The coverage of the taxation of “carried interest” in general circulation media has been deplorably simplistic. That’s understandable, but one would expect that one of the purposes of the TPC would be to provide more insightful and balanced coverage that would inform not only the general public but also mainstream journalists who rely on sources such as this for “expertise”. Unfortunately, Mr. Gleckman seems to have little idea of how the tax code works and even less idea of how the tax burdens and benefits are shared among private equity partners. If he does, he’s willfully ignoring it.

    Mr. Gleckman mentions briefly how general partners are taxed in these private equity partnerships. That’s, at best, half the story. How are the limited partners taxed? Partnership tax rules generally provide that the character of income in the hands of partners is the same as the character of income in the hands of the partnership. So, if a partnership acquires stock in a corporation, the capital gain (or loss) they derive when that stock is sold is capital gain not only to the partnership hands but flows through to the partners.

    The Code provides flexibility in how the gains and losses (and the character thereof) are shared by partners, general and limited. Limited partners, who usually put up most of the money, may generally agree to give the general partners a greater share in capital gain or loss than a strict allocation based on contributed capital would dictate. That’s part of the freedom to contract.

    Under normal circumstances, special allocation arrangements don’t cost the Treasury anything. If limited partners and general partners are all persons subject to ordinary US income tax, it should matter little to the Treasury if Limited Partner A gives up part of his capital gain to General Partner B. The tax take is the same—Partner A pays more and Partner B pays less. That’s part of the negotiated deal and is generally reflective of the amount of compensation A agrees to give to B. If A does not like it, he can negotiate a different deal or take his money elsewhere.

    Problems arise, though, when A is not a “normal” taxpayer. For example, if A is the Harvard or Princeton Endowment Fund with hundreds of billions to invest, the situation is quite different. Because they are not taxable at all on their income, they don’t care much about the character of income they derive. They are more than happy to give the General Partner a disproportionate share of capital gain income (offset, of course, by a lower percentage of income than would otherwise be the case). This is a classic negotiation result: tax exempts are, in essence, sharing the benefits of their tax exempt status. It’s a win, win situation.

    Understanding this and pointing all this out, though, requires some greater knowledge of the tax code, as well as the business world. These are two attributes that are sadly lacking in many of our “think tanks”, including this one. Besides, if you want to make a partisan populist charge, you get a lot more mileage ranting against private equity firms than you do against the Harvard Endowment Fund.

    Yes, the “carried interest” rule is a problem. When persons not subject to ordinary US tax are involved, this can result in arbitrage of tax benefits that was likely not intended by Congress. This is a “loophole” in the true sense of the word. But, rather than ranting against private equity firms (and indirectly a likely Presidential candidate) perhaps we should consider:

    1. Acknowledging that the abuse here is as much by tax exempts as their private equity partners ( a true “partnership”, indeed) and eliminating the tax exempt status on investments by the former;

    2. Adopting a common-sense rule, for example, that provides that the allocation and characterization of income to tax exempt partners must follow their pro-rata capital contribution. For this purpose, the definition of “tax exempt” that is used our “earnings stripping” rules of section 163(j) might be a good starting point.

  3. Michael Bindner  ::  8:23 am on January 13th, 2012:

    It is not funding of expiring tax provisions that will move the needle on this, but the prospect of a tax repatriation holiday on overseas profits, which is likely a provision that will be included. It would be helpful if TPC estimated various scenarios for this, using the Ways and Means white paper as a guide to determine whether the corporate income tax rate they cite is adequate, or whether they must go higher – assume that the corporate rate, dividends rate and capital gains rates are to be the same and that the increase must pay for the holiday and the expiring provisions, as well as getting rid of the AMT and taxing the carry.

  4. Michael Bindner  ::  8:24 am on January 13th, 2012:

    It sounds pretty cut and dried. Brokers provide a service and are paid for it. While investors should pay cap gains taxes, I fail to see why the brokers aren’t simply earning normal income, save for their ability to purchase members of the legislature.

  5. Vivian Darkbloom  ::  11:09 am on January 13th, 2012:

    It is only cut and dried if you think private equity partners are “brokers”. They are not.

  6. Senyor  ::  2:56 pm on January 13th, 2012:

    There’s tax code, there’s ranting, and there’s basic fairness. I can’t come up with a single reason in the world why the tax code should permit people like Mitt Ronmney to pay a lower tax rate than a teacher. And the Democrats are crazy not to run on that. Tax code revision should be a huge part of their election strategy.

    I would bet that the capital gains rates will under much scrutiny in the next few years. The GOP would eliminate all capital gains taxes if they could, and continue their overt dsire to have the middle class diappear altogether.

  7. Derek Scruggs  ::  4:32 pm on January 13th, 2012:

    The carried interest exception is BS. You should not get capital gains tax rates when there is no possibility for capital loss.

  8. Vivian Darkbloom  ::  6:11 am on January 14th, 2012:

    Of course, private equity partnerships experience capital losses all the time. And, the tax attributes of those losses normally flow to the general partner in the same proportion as gains.

    What you likely mean is that the general partner typically is not “out of pocket” or “at risk” for those losses because the loss may exceed his capital contribution, or his pro rata share of that contribution. (This is, of course a half truth because, in fact, almost all, if not all, the general partner’s compensation is “at risk”).

    What should be of interest to the Treasury is whether, at the end of the day, the Treasury collects less revenue from the arrangement than it would without the disproportionate allocation of gains and losses. (see my post below) If the Treasury does not lose from the arrangement, why should one’s freedom to enter into contractual terms with others be abridged? Or is freedom of contract BS? It seems to me that the best tax policy is to protect the interest of the public fisc and at the same time to protect such freedom of contract to the maximum extent consistent with those interests.. Let’s not throw the baby out with the bath water.

    The problem with the carried interest rule is that it can be used between partners who are subject to different tax regimes. Let’s fix that. Does it surprise you that a significant majority of funds provided by limited partners in these arrangements comes from “not-for-profit” (tax exempt) entities? Per a 2007 Joint Committee on Taxation review, 42 percent of private equity funds came from exempt public and private pension funds and 21 percent came from tax exempt endowment funds. A very small percent came from taxable corporate investors. See JCX-41-07. Another way to fix the problem (and raise much needed additional revenue) would be to do away completely with tax exempt status under section 501. Perhaps you should occupy Harvard Square?

  9. Del Ehresman  ::  2:21 am on January 31st, 2012:

    This discussion tends to ignore a basic fact: Much of the income (and/or losses) earned by private equity partners (and hedge fund managers, etc.) is from work performed in the ordinary course of business. As such, gains or losses should be treated as ordinary income. This should apply to any remuneration received (cash; the paper value of stock shares in a corporation; whatever arcane payment methods are thought up by the legal teams). When received, the payments should be taxed as ordinary income. If that money is then invested, any subsequent earnings will qualify as capital gains.

    A second point to remember: There is no justification for a low capital gains tax rate. Although investments might result in incremental improvements in the nation’s economy, there’s not much hard evidence that most investments lead to significant economic growth (such as additional jobs in the United States). It’s time to return to the Reagan-Clinton policies of taxing all income at the same rates. (And while we’re at it, apply the Social Security and Medicare tax to all income.)

    Vivian Darkbloom (whoever he/she is, hiding behind that nom de plume) offers self-serving rhetoric. The only good point made is the need to examine the tax-free status of major “charitable” foundations. Perhaps there’s a need to impose a minimal tax on the massive earnings of such organizations. Occupy Harvard and many other such institutions and organizations? Indeed!

  10. Karri  ::  7:54 pm on February 1st, 2012:

    Good debate…

    […]I can see a lot of different points of view on either side of this issue[…]…