Much attention has been directed to the taxation of certain fees related to the operation of some hedge funds. Most hedge funds are organized as partnerships, not corporations. This structure avoids double taxation on earnings and provides more flexibility in setting up economic arrangements among the partners.
These hedge fund partnerships are limited partnerships: they have a small number of general partners (GP) who manage the fund and a much greater number of investor limited partners (LP).
The LPs are investors in the fund and have no voice in the fund’s management. These LPs receive a share of partnership profits based on the amount of capital they have invested in the partnership. These profits are taxed as capital gains. The GP may also contribute a limited amount of capital to the fund, in which case, he receives a share of partnership profits based on his capital investment, just like the LPs.
Typically, the GP charges two annual fees for managing the hedge fund, commonly called the “2 and 20.” First, the GP receives a percentage of fund assets, typically 2%. This 2% fee is a fixed management fee, is not dependent on fund performance, and is taxed as ordinary income. Second, the GP receives a share, typically 20%, of the fund’s earnings once a designated profits benchmark has been met by the fund. This fee, the profits share, is carried interest and currently is taxed as capital gains.
The President's fiscal year 2013 budget proposal includes a provision changing the tax treatment of the carried interest, namely changing the character of the income from capital gains to ordinary income.
The Chamber opposes any changes to the tax treatment of carried interest outside the context of comprehensive tax reform. Further, as a matter of tax policy, carried interest represents the general partner’s “sweat equity” contribution to the partnership, in lieu of contributing capital. Venture capitalists risk time, money, and effort in setting up and running these funds. Accordingly, they have a stake in whether the fund succeeds or fails, so characterizing their carried interest as a capital interest (like investor limited partners) is appropriate.