Taxation of Hedge Fund and Private Equity Managers

Private equity and hedge funds are investment pools generally available only to institutions and individuals able to make investments in excess of $200,000. Private equity funds acquire ownership stakes in other companies and seek to profit by improving operating results or through financial restructuring. Hedge funds follow many strategies, investing in any market where managers see profit opportunities. The two kinds of funds are generally structured as partnerships: the fund managers act as general partners, while the outside investors are limited partners. Fund managers are compensated in two ways. First, to the extent that they invest their own capital in the funds, they share in the appreciation of fund assets. Second, they charge the outside investors two kinds of annual fees: a percentage of total fund assets, and a percentage of the fund’s earnings. The latter performance fee is called “carried interest” and is treated as capital gains under current tax rules.

Since the 110th Congress, concerns have been raised that the current tax rules are inequitable and inconsistent with some tax policy principles. Proposals that address this concern have focused on taxing some portion (or all in some cases) of carried interest as ordinary income. In the 113th Congress, S. 268 and the President’s FY2014 Budget Proposal would tax carried interest as ordinary income, while taxing another form of compensation, known as enterprise value, as capital gains income.

This report discusses the major issues surrounding the tax treatment of hedge fund and private equity managers and will be updated as legislative developments warrant.