Taxing Carried Interest: The Problematic Analogy to 'Sweat Equity'

Abstract

The enormity of the earnings reported by some private equity fund managers has drawn sustained public attention to how such earnings are treated under the income tax. Reformers call for eliminating the preferential capital gains treatment accorded to the carried interest portion of fund managers' service compensation. One of the most prominent and thus far successful arguments against reform compares the tax advantage of carried interest to the supposed tax advantage routinely enjoyed by business owners who work in their own business and compensate themselves with sweat equity rather than salary. This paper argues that sweat equity is not only an inapt analogy for carried interest, but is, on its own terms, misconceived. The tax advantage of carried interest is a matter of exploiting differences in the marginal tax rates of fund managers and fund investors. The tax advantage to sweat equity is largely nonexistent.