"I think you can argue that capital gains shouldn't be taxed differently than income at all (not sure what I think of that, honestly), but if carried interest has to be in either the "income" bucket or the "gains" bucket, it looks more like gains to me."
Looks more like income to me - fees paid to people for managing money that they themselves have not put at risk.
Again, we're not talking about getting carried interest - we're talking about the taxes on that carried interest. They put the capital at risk, but this is no different than any fee-based service, thus it is income rather long term capital gains.
If they took part of their salary and opted (or were required by LP's) to invest that money in their fund, should any gains there be taxed as capital gains or ordinary income? They would clearly be capital gains.
What is the difference between that and carried interest? The only thing I can think of is that it's not taxed as ordinary income before being invested, which is a fair criticism. On the other hand, you don't get a tax benefit if you lose that money in the CI case (which happens a lot), so it balances out at least to a degree.
"Because the fees charged by the mutual fund guys are fixed - it's a straight percentage of assets. Just like the fees charged by hedge funds which are taxed as ordinary income."
Taxable methodology isn't generally determined by the way you earn your income. The concept of long term capital gains was created to reward investors (those who invest their own capital) who hold capital in a given investment vehicle for over a year, not for whether or not they are taking on risk, or whether they are paid out based on a fixed fee or fixed percentage of profit. We don't tax waiters at a different rate for the money they get on tips (sweat equity) vs. their base salary.
Fees charged by private equity are also fixed - they are a fixed percentage of profit. So again, I don't see why this is any different. We have an investment vehicle taking in money, making investment decisions on the behalf of their investors and then making a percentage of the profits - all normal activities - nothing that warrants special tax treatment.
> Taxable methodology isn't generally determined by the way you earn your income. The concept of long term capital gains was created to reward investors (those who invest their own capital) who hold capital in a given investment vehicle for over a year, not for whether or not they are taking on risk, or whether they are paid out based on a fixed fee or fixed percentage of profit.
There's a pretty good argument that some special treatment of income from long-term holdings (or, at least, something that accounts for them) is necessary in a system with progressive taxes on annual income, because otherwise small investors with infrequent realizations of income from long-term holdings would be taxed more on their income (on average) than people with the same average annual income who made constant income year-to-year.
OTOH, one can argue that the particular mechanism of long-term capital gains is a bad mechanism for that because it doesn't account for similarly irregular non-capital income (e.g., a writer whose income is mainly royalties that are concentrated immediately after new book releases who infrequently releases books that are bestsellers, but with several years of minimal income in between) and, at the same time, undertaxes capitalists that can afford enough in long-term holdings that rotate to realize constantly high income from long-term holdings.
Things like hedge funds and carried interest are sort of nibbling around the edges.
I'd have no issue with their own investments in the fund being taxed as long term capital provided they have held the investment for a year when the profit is taken.
Here's a simple way to think about it - an ordinary RIA invests money on behalf of their clients. The fees they get for that service are taxed as ordinary income. Why should carried interest be any different when the money is coming from clients? And why should carried interest be taxed at a lower rate regardless of hold time? The simple answer is that these fees aren't any different - and therefore should be taxed at the same rate in my opinion.
Because the fees charged by the mutual fund guys are fixed - it's a straight percentage of assets. Just like the fees charged by hedge funds which are taxed as ordinary income.
To take it a step further, should entrepreneurs pay ordinary income tax on their gains when they sell their company if they didn't invest any of their own money? It's the same thing. Carried interest is just a fancy name for sweat equity.
"Because the fees charged by the mutual fund guys are fixed - it's a straight percentage of assets. Just like the fees charged by hedge funds which are taxed as ordinary income."
Taxable methodology isn't generally determined by the way you earn your income. The concept of long term capital gains was created to reward investors (those who invest their own capital) who hold capital in a given investment vehicle for over a year, not for whether or not they are taking on risk, or whether they are paid out based on a fixed fee or fixed percentage of profit. We don't tax waiters at a different rate for the money they get on tips (sweat equity) vs. their base salary.
Fees charged by private equity are also fixed - they are a fixed percentage of profit. So again, I don't see why this is any different. We have an investment vehicle taking in money, making investment decisions on the behalf of their investors and then making a percentage of the profits - all normal activities - nothing that warrants special tax treatment.
Comparing selling your company to carried interest isn't appropriate - apples and oranges - but to your entrepreneurs example: if they accept investment in their company, then their company has shares. Gains on those shares are treated exactly the same as any other share in any company - short term gains on stock held less than a year or long term if you've held it a year or longer. This is why many people exercise their options in a startup as a way to start that clock as soon as possible to avoid short-term tax consequences.
Again - PE firms are offering a service and will receive a good profit for their hard work. But that work often involves minimal capital on their part and therefore should not be treated as if it is their capital at risk.
Looks more like income to me - fees paid to people for managing money that they themselves have not put at risk.