CMV.TAX NOTES.10.22.12

There is much debate over the number of U.S.
jobs that would be shipped overseas if a territorial
system were adopted.49 The bottom line is that the
current deferral system acts as a significant subsidy
for foreign investment, and the adoption of a terri-
torial system would increase that subsidy. However,
the adoption of an imputation system with a reduc-
tion in the corporate tax in the amount of the
revenues gained from the adoption of the imputa-
tion system would clearly increase the attractive-
ness of U.S. investment to both domestic and
foreign companies, and that increased investment
would increase U.S. employment.
G. Conclusion
This article has summarized and analyzed the
following tax policy issues in the ongoing debate
between Obama and Romney: the structure of the
individual tax rates, the taxation of capital gains
and dividends, and the taxation of foreign business
income. The article argues that the individual rate
structure should be more progressive than the rate
structure before the Bush tax cuts; the tax rates on
capital gains and dividends should be returned to
their pre-Bush rates; and an imputation system
should be adopted for taxing foreign income, the
revenue savings from which should be used to
significantly lower the corporate tax rate. All those
policy options would require Romney and his run-
ning mate, House Budget Committee Chair Paul
Ryan, to violate their ‘‘no new tax’’ pledge to Grover
Norquist’s organization.50
Carried Interest Taxation and
Private (and Horizontal) Equity
By Cory M. Vargo
Introduction
Analyzing the taxation of carried interest, a hot-
button issue in any modern tax reform conversa-
tion, is a task that requires much more complex
thought and consideration than one would initially
expect. To accurately reflect on the economics of
carried interest and how the realization of that
income should be taxed, issues including income
characterization, equality, administrative practical-
ity, and broad economic impact must be examined
in depth.
In the context of private equity funds, carried
interest is generally defined as a right to a dispro-
portionate allocation of profits from a partnership
when a manager has paid something for the man-
ager’s interest.1 In most circumstances the manager
receives a general partner interest in the partnership
by contributing a nominal amount of capital, and
limited partners assume their roles as passive inves-
tors by contributing the remaining capital, typically
49
See Kimberly A. Clausing, ‘‘A Challenging Time for Inter-
national Tax Policy,’’ Tax Notes, July 16, 2012, p. 281, Doc
2012-14139, or 2012 TNT 137-5; Michael M. Gleeson, ‘‘Romney
Corporate Tax Plan Would Create Jobs Overseas, Obama Says,’’
Tax Notes, July 23, 2012, p. 367, Doc 2012-15024, or 2012 TNT
137-1; Gary Clyde Hufbauer, ‘‘800,000 Jobs Shipped Overseas?
Check the Math!’’ Tax Notes, Aug. 6, 2012, p. 717, Doc 2012-15649,
or 2012 TNT 152-6; Clausing, ‘‘Response to Hufbauer: Territorial
System Has Risks,’’ Tax Notes, Aug. 13, 2012, p. 825, Doc
2012-16954, or 2012 TNT 156-7; and Hufbauer, ‘‘Rejoinder to
Clausing,’’ Tax Notes, Aug. 20, 2012, p. 963, Doc 2012-17251, or
2012 TNT 161-11.
50
See Thompson, The Grover Pledgers: Governor Romney and
Congressman Ryan — An Excerpt from the Book: The Obama vs.
Romney Debate on Economic Growth: A Citizen’s Guide to the Issues
(Aug. 13, 2012), available at http://papers.ssrn.com/sol3/
papers.cfm?abstract_id=2128824.
1
Paul Carman, ‘‘Taxation of Carried Interests,’’ 87 Taxes 111
(2009).
Cory M. Vargo
Cory M. Vargo is a senior
associate at Pricewater-
houseCoopers LLP in Bos-
ton, focusing primarily on
mergers and acquisitions
and global-structuring-
related consulting. He
wishes to thank Brigitte
Muehlmann and Joe Real-
muto for their assistance
throughout the review pro-
cess, with special thanks to Muehlmann for her
guidance and tax policy insight and to Realmuto
for a helpful discussion on practical uses of carried
interest.
In this article, Vargo provides a general introduc-
tion to carried interest in a modern and practical
sense and compares various suggestions for carried
interest tax reform, noting how opposing view-
points have framed the arguments in terms of
equality and economics. He also raises questions
regarding the historically narrow-minded nature of
carried interest reform efforts.
The views expressed herein are those of the
author and do not necessarily represent those of
PwC.
COMMENTARY / VIEWPOINTS
TAX NOTES, October 22, 2012 425

upwards of 99 percent of the fund’s initial value.
Limited partners are entitled to receive a return of
their invested capital plus an additional return of
up to a specified amount, usually 8 percent or 9
percent (the hurdle rate). If there are profits above
that amount, the limited partners receive allocations
so that they will get 80 percent of total profits.2 The
remaining 20 percent allocation, after the hurdle
rate is reached, is the carried interest paid to the
manager. To derive the total profits of the partner-
ship, it is common for the manager to receive an
annual payment of 2 percent of all partnership
capital from the limited partners in addition to a
management fee from the investee companies for
services performed, both of which are characterized
and taxed as ordinary income.
Because of the complexity and the enormous
level of income involved in carried interest arrange-
ments, there are many differing opinions on which
related issues should hold more weight and essen-
tially how this income should be taxed. Overall, a
partnership profits interest is the single most tax-
efficient form of compensation available without
limitation to fund managers and highly paid execu-
tives.3
Importance of the Issue
The importance of the issue has grown over the
past years for various reasons, including changes to
both U.S. taxation and the size of the private equity
industry as a whole. The economic challenges faced
by the United States and many European nations
have hit the less fortunate harder than the wealthy,
and class disparity is becoming widely apparent.
Critical views of the current taxation of carried
interest consider reform as a way to decrease the
ever-burgeoning U.S. fiscal deficit as well as ensure
high-income earners are paying their fair share to
support the government. Although carried interest
is a considerable source of income for some wealthy
individuals at a time the U.S. government is search-
ing for effective ways to offset increased spending,
narrowly increasing taxation on this type of income
will not create enough tax revenue to materially
affect the U.S. fiscal deficit. Imposing higher tax
rates on Wall Street investors may have popular
appeal, but compelling arguments must be made to
bring about any tax reform. Potential policy consid-
erations include fairness, taxpayer ability to pay the
tax, the impact of taxation on market and invest-
ment decisions, simplicity, administrability, and the
ability of a proposal to raise funds for the govern-
ment.4
It is easy to understand why fairness is a major
concern in this context. From an equality standpoint,
the recipients of carried interest are viewed by the
public as wealthy individuals earning millions of
dollars while paying a tax rate lower than the av-
erage American’s tax on wages. Another consider-
ation is the importance of horizontal equity, which
requires equality in taxation of those in similar eco-
nomic and social positions. It seems inequitable to
allow sponsors of private equity funds to get capital
gains treatment when other service providers, most
of whom earn less money, are taxed at ordinary
income rates. But any change in the treatment of
holders of carried interest would itself violate hori-
zontal equity by treating them less like individuals
engaged directly in the activity — that is, less like
anyone else who uses third-party capital to buy an
asset instead of using a partnership as a conduit.5
It is difficult to make direct comparisons to
carried interest; however, similarities can be seen in
various deferred compensation arrangements, both
nonqualified and incentive stock options, the issu-
ance of common stock while preferred stock is
outstanding, and founders’ shares. Another factor
to be considered in determining comparables is that
a carried interest is commonly subject to a clawback
requirement. Essentially, that means the carried
interest is subordinated to the limited partner inter-
ests in the sense that if the hurdle rate is exceeded
and the fund’s future losses then drop the total
profit below the hurdle rate, the manager will be
required to make payments to the limited partners
(assuming carried interest had been paid) to respect
the economics of the required allocations provided
in the partnership agreement.6
Although equality is an important issue in tax,
consideration must be given to broad economics
and to how a change in tax law will affect invest-
ment decisions. For example, the 2003 reduction in
dividend tax rates from ordinary income rates to a
maximum of 15 percent caused dozens of compa-
nies to issue dividends for the first time, including
Microsoft’s first-time dividend distribution of $32
billion. That reform not only affected investors
whose major income source was dividend income,
it also allowed for many retirees to receive dividend
income on their retirement-focused investments.7
2
David Weisbach, ‘‘The Taxation of Carried Interests in
Private Equity,’’ 94 Va. L. Rev. 715 (2008).
3
Victor Fleischer, ‘‘Two and Twenty: Taxing Partnership
Profits in Private Equity Funds,’’ 83 N.Y.U. L. Rev. 1 (2008).
4
Carman, supra note 1.
5
Weisbach, supra note 2.
6
Carman, supra note 1.
7
Editorial, ‘‘Obama’s Dividend Assault,’’ The Wall Street
Journal, Feb. 23, 2012.
426 TAX NOTES, October 22, 2012

The broad effects of any reform, combined with
the fact that the U.S. government will likely reach
its $16.394 trillion debt ceiling before the end of
2012,8 require not only that an informed discussion
on carried interest taxation take place, but also that
an appropriate method be used to properly hash
out all related issues.
Current Status
Income earned as carried interest, viewed simply
as an allocation of income from a partnership,
retains its character when received by a partner and
is taxed accordingly (as a basic function of partner-
ship taxation). When that income consists of quali-
fied dividends or long-term capital gains, the
managers are taxed at the 15 percent rate applicable
to those forms of income.9 Currently, no special rule
exists that would allow taxing income received
from a profits interest held by a fund manager (or
general partner) differently from limited partners
who do not receive carried interest. While the
source of income allocated to the general partner is
the same as that allocated to limited partners, the
argument for treating the partners’ income differ-
ently centers on consideration paid in exchange for
the right to their respective allocation percentages
(most importantly the potential 20 percent alloca-
tion general partners receive for their services).
Also, reformers argue that the current treatment of
carried interest violates the principles of both hori-
zontal and vertical equity. That is, individuals with
the same income should owe the same in taxes
regardless of the form of income, and that those
who earn more should pay more in taxes than those
who earn less.
Some modern proposals assert that the general
partner should be taxed on the initial receipt of his
profits interest, especially when earning a 20 per-
cent allocation is likely in the future.10 However,
Rev. Proc. 93-2711 provided that the receipt of that
interest shall not be taxable in the United States. It
may be true that a manager receives something of
value at the moment the partnership agreement is
signed, but the difficulty of valuation, among other
considerations, prevents U.S. tax law from treating
that receipt as a taxable event.12 Although the
receipt of a profits interest is taxed in many other
jurisdictions, if the receipt of the partnership inter-
est is the element of compensation, a recharac-
terization of all the income and gain for the carried
interest is a change in some basic concepts in U.S.
taxation of partnerships and the nature of being a
partner.13
While specifics may differ, most arguments for
change focus on the services provided by the man-
ager and seek to tax any related income at ordinary
rates. To ensure that investment advisers pay ordi-
nary income tax on service-flavored income the
same way construction workers and plumbers do,14
most proponents of increasing tax on carried inter-
est, including President Obama, believe in making a
general partner’s profit share taxable at regular
income tax rates up to 35 percent, instead of the
current capital gains tax rate of 15 percent.15 This
argument appears to be much more sustainable
than taxing the receipt of a profits interest; however,
fairly basic counterarguments do exist: All the fea-
tures that commentators argue make holders of
carried interests analogous to service providers are
found equally in investors or entrepreneurs. A
comparison of income earned as carried interest
with income earned by an individual investor using
a margin account would provide for either ordinary
income treatment for both or a clear inconsistency
in tax policy.16 Also, those who build a business
from the ground up receive shares in a company
(founders’ shares) with a low or zero basis, often
take a small salary, and receive almost all their
compensation through the sale of their founders’
shares, which are taxed at capital gains rates. The
point is that although fund managers clearly try to
direct the strategy and specific investments of a
8
Damian Paletta, ‘‘Geithner: U.S. Likely to Hit Debt Ceiling
Before Jan. 1,’’ The Wall Street Journal, Feb. 16, 2012.
9
Alan Viard, ‘‘The Taxation of Carried Interest: Understand-
ing the Issues,’’ 61 Nat’l Tax J. 3 (Sept. 2008).
10
However, economic data show that as of 2007, more than
60 percent of expected revenue earned by venture capital and
buyout funds was derived from fixed management fees, while
income from carried interest represented approximately one-
third of the total revenue to the private equity funds’ general
partners. Only about 40 percent of funds generated carried
interest for partners, and among those that did, amounts were
concentrated in a small group of larger funds. See Joint Com-
mittee on Taxation, ‘‘Present Law and Analysis Relating to Tax
Treatment of Partnership Carried Interests,’’ JCX-41-07 (July 10,
2007), Doc 2007-16135, 2007 TNT 133-9.
11
1993-2 C.B. 343, Doc 93-6562, 93 TNT 123-7.
12
Fleischer, supra note 3. Further, for the receipt of a profits
interest to be treated as a nontaxable event, the partnership’s
income stream cannot be substantially certain and predictable,
the partnership cannot be publicly traded, and the interest
cannot be disposed of within two years of receipt. See prop. reg.
section 1.83-3(l).
13
Carman, supra note 1. For a discussion supporting current
treatment, and for relative comparisons beyond the narrow
analysis of carried interest, see Philip F. Postlewaite, ‘‘15 and 35:
Class Warfare in Subchapter K,’’ Tax Notes, Jan. 26, 2009, p. 503,
Doc 2008-26704, or 2009 TNT 15-47.
14
Glenn E. Dance et al., ‘‘It Sounded So Simple — The Effort
to Reform the Taxation of Carried Interests,’’ J. Passthrough
Entities (Sept. 2010).
15
Hazel Bradford, ‘‘Carried Interest Tax Increase May Come
to Pass This Time,’’ 39 Pens. & Inv. 21 (2011).
16

fund, individual investors and entrepreneurs en-
gage in the same decision-making but without the
threat of a drastic increase in taxation.
Obama has recognized that while most of a
manager’s carried interest can be associated directly
with the services he performs, a distinction must be
made to some extent, considering the nominal
funds contributed as an equity interest. In the past,
Obama’s plan would recast it as an ‘‘investment
services partnership interest,’’ which would expose
only the partner’s share of income not attributable
to invested capital to the regular income tax rates.17
However, the president’s fiscal 2013 budget does
not provide that detail. The 2013 blue book instead
simply states, ‘‘The President proposes to eliminate
the [carried interest] loophole for managers in in-
vestment services partnerships and to tax carried
interest at ordinary income rates.’’ Regardless, it is
unpredictable whether the president’s budget will
become law.
History
Carried interest in its modern sense has been
used as a form of private equity management
compensation for decades; however, the tax levied
on that income did not become controversial until
the mid- to late 2000s. Two major factors played
pivotal roles in initiating the push for reform. In
conjunction, these historical factors clearly thrust
the rapidly growing form of income into the sights
of congressional debate.
While big banks and wealthy individuals have
played major roles in global economies for genera-
tions, the levels of corporate investment under the
private equity and hedge fund umbrellas have
exploded since the early 1990s. The use of private
equity (by raising capital from sources such as
pension funds, endowments and foundations, and
wealthy individuals) has expanded substantially in
the past 20 years. From 1980 to 1995, the amount of
capital under management in the private equity
market increased from roughly $5 billion to more
than $175 billion. In 2006 private equity firms raised
more than $240 billion in capital, up from less than
$25 billion a year in the early 1990s.18 In 2007
private equity funds managed approximately $1
trillion of capital globally, and the 13 largest of those
funds had an estimated $374 billion in assets under
management.19
Carried interest’s mere existence cannot be the
lone factor driving the push for tax reform. Even
Americans who believe carried interest should be
taxed at ordinary income rates would not suggest a
form of profit-sharing should be illegal merely
based on its lucrativity. To do so, especially regard-
ing a form of corporate investment in a capitalist
society, would be inherently un-American. In fact,
carried interest is used heavily by the real estate
industry, hedge funds, and venture capitalists, all of
which create the growth and jobs needed to sustain
a healthy economy.
Through most of the 1980s and 1990s, capital
gains were taxed similarly to ordinary income
(which is a standard many hope to achieve for
capital gains received in the form of carried inter-
est). This changed when President George W. Bush
signed the Economic Growth and Tax Relief Recon-
ciliation Act of 2001 into law and created a major
disparity in the tax rates charged on ordinary
income and capital gains. The act provided for
reduced long-term capital gains tax rates of 0 per-
cent for individuals in the 10 and 15 percent tax
brackets, and a maximum of 15 percent for those in
the highest tax brackets (short-term capital gains
remain taxed at ordinary income rates). These re-
duced tax rates alone were not enough to politicize
the characterization of gains received through car-
ried interest arrangements. Once coupled with the
rapid growth in the private equity sector (and the
amount of carried interest earned by individuals) in
the mid- to late 2000s, however, carried interest tax
reform became a common subject of debate in
Congress.
In June 2007 House Ways and Means ranking
minority member Sander M. Levin, D-Mich., and
Senate Finance Committee Chair Max Baucus,
D-Mont., introduced the first serious bills designed
to alter the taxation of carried interest. Levin’s bill
would have added section 710 to the code.20 It
provided that net income derived from, and gain on
the disposition of, an investment services partner-
ship interest (ISPI) would be treated as ordinary
income for the performance of services, and based
on the definition of ISPI, carried interest in private
equity funds would be characterized as ISPI, and its
disposition would give rise to ordinary income.21
17
Bradford, supra note 15.
18
Testimony of Peter Orszag, Congressional Budget Office,
‘‘The Taxation of Carried Interest’’ (Sept. 6, 2007).
19
JCT, supra note 10.
20
On analysis of the specifics offered in proposed section 710,
many authors commented on the proposal’s lack of practicality.
See Howard E. Abrams, ‘‘A Close Look at the Carried Interest
Legislation,’’ Tax Notes, Dec. 3, 2007, p. 961, Doc 2007-25737, or
2007 TNT 233-35; Karen C. Burke, ‘‘Fuzzy Math and Carried
Interests: Making Two and Twenty Equal 710,’’ Tax Notes, May
24, 2010, p. 885, Doc 2010-9757, or 2010 TNT 100-7; Jack S. Levin
et al., ‘‘Carried Interest Legislative Proposals and Enterprise
Value Tax,’’ Tax Notes, Nov. 1, 2010, p. 565, Doc 2010-21730, or
2010 TNT 211-3.
21
Megan Lambart Meier, ‘‘The Carried Interest Controversy:
The U.S. and U.K. Reform Movements of 2007,’’ Tax Notes Int’l,
Apr. 21, 2008, p. 255.

Throughout 2007 the House deliberated the Levin
bill and the Senate debated the Baucus bill (which
essentially proposed to require publicly traded pri-
vate equity partnerships to pay corporate income
tax). The House passed the Levin bill in 2007, but
Bush threatened to veto the bill if it passed the
Senate. Baucus conceded that the bill did not have
enough support in the Senate, and the carried
interest provision was removed in the final ver-
sion.22 Although Levin and Baucus failed to change
the way carried interest was taxed, they success-
fully alerted Congress to their belief that tax in-
equalities were at work in the private equity world.
Obama even used Levin’s ISPI concept as the basis
for determining what portion of a manager’s earn-
ings would be taxed at ordinary rates.23
It was not until November 2007 that the House
passed the bill Levin had orchestrated; however, the
Congressional Research Service began issuing re-
ports, mostly authored by Mark Jickling and
Donald Marples, in July of that year. As time went
on, the CRS issued enhanced versions of its initial
carried interest report, as congressional action made
it clear that reform was on the forefront of many
lawmakers’ minds.24
Decreased capital gains tax rates and increased
private equity investment have made it easy for
proponents of change to describe carried interest as
a source of economic inequality. The key notions of
most reform proposals revolve around the idea that
specific forms of investment income (carried inter-
est) should be taxed at higher rates. However, with
the November elections looming, it remains to be
seen if the capital gains and dividend tax rate
preference will be extended for those earning more
than $200,000 person per year, if at all.
Academic Analysis
Most independent analyses of the current status
of carried interest taxation agree that some sort of
reform is necessary to increase equality in our tax
code. What seems to be even more agreeable is that
if reform is attempted, it must be approached in a
delicate manner, giving consideration to an
abudance of issues. Regardless of personal views,
strong arguments on both sides of the debate take
into account the economics of the carried interest
arrangement, the effect reform will have on the
behavior of private equity managers and U.S. in-
vestment as a whole, and the importance of avoid-
ing significant alterations to the major concepts of
subchapter K.
In ‘‘Finding the Right Balance: A Critical Analysis
of the Major Proposals to Reform the Taxation of
Carried Interests in Private Equity,’’25 Christopher
Livingstone takes an empirical approach to analyze
the current status of the topic, but more impor-
tantly, the current proposals for reform. Focusing on
taxing carried interest in a method that most accu-
rately reflects the underlying economics, Living-
stone notes that in reality, carried interest is not
wholly compensation for services or a return on a
capital investment, but a combination of the two. As
such, carried interest should be taxed in a way that
accurately reflects its dual nature. This mind-set not
only allows an approach that will fairly tax the
income of fund managers, but also seems to be
concerned with preserving current partnership
taxation. Livingstone wisely points out that the
current tax framework for carried interest has been
part of the partnership tax system for more than 50
years and that despite its perceived flaws, one
advantage of the current tax system is that it has
been around for decades and as a result is predict-
able and relatively well understood by those it
affects.26 Simply put, certainty in the tax system is a
rarity nowadays and should be respected whenever
possible.
Moving on to critique a couple common pro-
posals for reform, Livingstone dissects two ideas of
taxing carried interest: treating the income entirely
as ordinary income when received, and taxing
imputed income on an implied loan connected with
a fund’s management. Taxing carried interest en-
tirely as ordinary income can be accomplished in
one of two ways: by altering the tax code to treat all
income received by a fund manager as ordinary
income, or attempting to treat carried interest trans-
actions as between a partnership and someone who
22
Id.
23
Bradford, supra note 15.
24
In the 112th Congress, the president’s budget proposal
would make carried interest taxable as ordinary income. In the
111th Congress, the House-passed American Jobs and Closing
Tax Loopholes Act of 2010, H.R. 4213, would have treated a
portion of carried interest as ordinary income, whereas the Tax
Extenders Act of 2009, H.R. 4213, H.R. 1935, and the president’s
2010 and 2011 budget proposals would have made carried
interest taxable as ordinary income. Also, in the 110th Congress,
H.R. 6275 would have made carried interest taxable as ordinary
income. See Donald Marples, ‘‘Taxation of Hedge Fund and
Private Equity Managers: Characterization of Carried Interest,’’
CRS (Mar. 10, 2011), Doc 2011-5224, 2011 TNT 49-50.
25
Christopher Livingstone, ‘‘Finding the Right Balance: A
Critical Analysis of the Major Proposals to Reform the Taxation
of Carried Interests in Private Equity,’’ 62 Tax Law. 241 (2008).
26
Id.

is not a partner. Livingstone predicts that regardless
of which method one chooses, taxing carried inter-
est entirely as ordinary income would not comport
with economic reality and would be ineffective in
practice.27
Another, more reasonable, approach is to treat
carried interest as a temporary borrowing of capital
from the limited partners, which would treat a
general partner with a 20 percent carried interest as
if he had borrowed 20 percent of the total capital
invested in the fund for the life of the fund, and
would impute ordinary income on the manager
based on the amount of interest that would have
been paid under normal lending circumstances. The
imputed ordinary income would increase the man-
agers’ basis in his respective investments in order to
prevent taxing the same income twice. The man-
ager, therefore, pays tax on imputed interest on the
deemed loan as well as on the capital gains received
through the normal carried interest arrangement.
Despite some of its flaws as proposed, the implied
loan approach gets much closer than the alterna-
tives to taxing the economic reality of carried inter-
est, by treating it as part ordinary income and part
capital gain.28 This essentially would provide a
more economically reasonable fiction by assuming
a fund manager would borrow 20 percent of the
value of the fund to increase his direct equity
investment, eliminating the disparity between the
minor equity investment made in reality and the
high profits interest granted.
This is certainly a logical approach to taxing
carried interest; however, reform proponents are
sure to argue that it does not go far enough. Further,
Livingstone seems convinced that future change in
the taxation of carried interest is inevitable (which
remains to be seen), and because of this pays no
attention to the effect reform would have on the
U.S. economy.
John Rutledge, chair of Rutledge Capital LLC,
takes a more economic approach to discussing
reform. Rutledge notes that a higher tax bill will
simply cause managers to alter their funds’ eco-
nomics, and the additional burden will fall on all
parties involved. In this case, general partners will
pay through lower after-tax gains, limited partners
will pay through higher partnership costs and
lower returns, beneficiaries will pay through lower
pension benefits, and owners and managers of
operating companies will pay through lower values
for the companies they are working to build.29 The
demonization and subsequent increase in taxation
of carried interest will cause fund managers to alter
their investments so that the compensation they
currently receive as carried interest will look like
something entirely different, while still receiving
capital gains tax treatment. Using founders’ shares,
stock options, or contingent notes (by simply struc-
turing interest rates to allow an 8 percent return for
limited partners) in lieu of carried interest will
allow managers to easily prevent incurring a higher
tax bill if change were to occur. A move to increase
tax on investment will lead to less efficient and less
desirable capital markets in the United States, raise
little to no additional tax revenues (as managers
will simply restructure their operations), or both.
Samuel D. Brunson provides a similar analysis to
Livingstone but proposes a unique method of taxa-
tion. Brunson’s suggestion would tax carried inter-
est in a manner that would mark to market the
manager’s interest in the fund, essentially meaning
an investment fund manager would pay taxes an-
nually on the amount of carried interest allocated to
her — irrespective of whether the fund had sold
assets — and would pay taxes on that amount at
ordinary rates.30 The fund manager’s basis would
then be increased by the ordinary income recog-
nized, and would be used in the future to offset
capital gains arising beyond the recorded increase
in value from marking to market. This mark-to-
market method of income recognition claims to
provide for a mix of ordinary and capital gain
treatment. However, Brunson would permit the
funds to determine their own method of annual
valuation for tax purposes, likely triggering a sig-
nificant level of manipulation in determining fair
market value, especially since the size of annual tax
payments are at stake. Although many funds main-
tain annual valuations for book purposes, the level
of scrutiny required to comfortably rely on those
values for tax purposes would be administratively
burdensome for the IRS.
Further, Brunson’s method appears to defy one
of the key tenets of U.S. taxation — that a realization
event must occur before taxation. Forcing an annual
valuation for tax purposes (albeit a potentially
unsubstantiated and self-assessed valuation) essen-
tially requires a manager to pay tax on appreciation
of a security (the carried interest) when no realized
wealth increase has occurred. Brunson’s defense of
this position focuses on the fact that carried interest
27
Id.
28
Id.
29
John Rutledge, ‘‘The Impact of Increasing Carried Interest
Tax Rates on the U.S. Economy,’’ 11 J. Alt. Inv. 62 (2008).
30
Samuel D. Brunson, ‘‘Taxing Investment Fund Managers
Using a Simplified Mark-to-Market Approach,’’ 45 Wake Forest
L. Rev. 79 (2010).

recipients are always wealthy, which is not true.31
Because many new funds have carried interest
recipients who are either not wealthy or have nearly
all their capital tied up in investments, Brunson’s
point clearly falls short. His argument is scary, more
than anything else, because it claims taxing an
individual on income not yet received is appropri-
ate simply because that individual potentially has
the liquidity to pay the tax bill.
Brunson’s simplified mark-to-market approach is
an interesting suggestion for reforming the taxation
of carried interest, but it is not a practical solution to
a rather complex problem. David Weisbach, on the
other hand, provides various clear examples sup-
porting why raising taxation on fund managers is a
bad idea.
The first compelling point made by Weisbach
concerns equality. Many claim that the way carried
interest is taxed is unfair because those who earn
the same amount of money by performing services
pay tax at ordinary income rates. However, anyone
who buys stock through a margin account and
profits on the sale is using in part someone else’s
money and their own effort and ideas about stock
valuations to make money. Capital gains treatment
is standard even though the gains may be attribut-
able to labor effort. Further, any change in the
treatment of holders of carried interest would itself
violate horizontal equity by treating them less like
individuals engaged directly in the activity — that
is, less like anyone else who uses third-party capital
to buy an asset.32
In essence, carried interest is an agreed-on allo-
cation between the general partner and limited
partners providing for conditional profit percent-
ages to be paid to specific partners. Complex part-
nership allocations are popular, and implementing
differing tax rates on a specific form of allocation
would add an unprecedented level of stress to the
partnership world by defying the entire notion of
passthrough income. Because these payments are
simply agreed-upon allocations, passthrough of
capital gain is therefore mandated by this basic
premise of partnership taxation.33
Weisbach’s final point worth discussing focuses
squarely on the reasoning for lower capital gains
tax rates in the first place.34 It is undisputed that the
preferential treatment for capital gains is to support
private investment, yet reformers are clearly at-
tempting to attack income that is earned on appre-
ciation of property simply because of who received
the income. After all, private equity activity in-
volves entrepreneurial investing, which falls in the
bull’s-eye of items getting the capital gains prefer-
ence. Those who do not believe in a broad-based
capital gains preference may believe that it should
not apply to private equity, but they should also
believe that the problem is not particularly with this
class of activity and that the best and only way to
solve the problem is to fix capital gains rates
generally.35
In general, while most proponents of change can
eloquently explain why they believe carried interest
should be taxed at higher rates, it is only those who
oppose reform who actually analyze the potential
economic downsides and are therefore able to make
the most compelling arguments.
Lessons Learned
One can learn a lot by researching the history and
political discourse surrounding the reform of car-
ried interest taxation. The Levin and Baucus pro-
posals as well as the many suggestions in the legal
and empirical papers discussed here provoke sub-
stantial thought around the issue. It is difficult,
however, to draw anything from the inclusion of
drastic tax reform in a presidential budget, most
notably because of the near-impossibility of passage
(specifically in Obama’s fiscal 2013 proposal) and
the highly politicized nature of recent budgetary
processes. Luckily, we have seen lawmakers along
with third-party authors frame the subject in the
manner of legitimate discussion (most obviously by
presenting bills to Congress). This not only forces us
to realistically consider reform but also raises im-
portant questions.
31
Brunson later notes that although his proposal will not
solve the liquidity problem, investment fund advisers face this
regardless of the tax rate and that most carried interest struc-
tures provide for fund managers to withdraw cash from the
fund to make required tax payments. The key difference ignored
here is that while it is true that a partner’s allocations are taxed
currently, actual cash distributions made through carried inter-
est (outside any arrangement specifically for tax-related pay-
ments) occur rarely (sometimes only once every five to seven
years). See Brunson, ‘‘How to Tax Mitt Romney,’’ Tax Notes, May
28, 2012, p. 1137, Doc 2012-7435, or 2012 TNT 104-3.
32
33
Id.
34
See Gerald Auten, ‘‘Capital Gains Taxation,’’ The Encyclope-
dia of Taxation & Tax Policy, 46-49 (2d ed.). Capital gains currently
receive a lower tax rate for many economic reasons. Several
studies have shown that a large percentage of reported capital
gains reflect the effects of inflation and that capital gains of
lower- and middle-income taxpayers commonly represent not
only nominal gains but real economic losses because of infla-
tion. Higher rates on capital gains also create a lock-in effect,
which imposes efficiency losses when investors are induced to
hold suboptimal portfolios with inappropriate risk or diversifi-
cation, or to forgo investment opportunities offering higher
expected pretax returns. Finally, capital gains tax on corporate
stock can be viewed as a component of the double taxation of
corporate income, which can raise both equity and efficiency
concerns.
35
Id.

Taking a bird’s-eye view of carried interest and
the related proposals for reform raises the question:
Why is reform of carried interest, specifically, im-
portant? It appears to be a question of equality more
than anything else, but another question is: What
kind of equality is at stake?
In February 2007, about one year from when
Levin had first heard of carried interest, and only
days after Blackstone Group closed the largest
buyout in history for the sum of $39 billion, its chair,
Stephen Schwarzman, threw himself a birthday
party that reportedly cost between $3 million and
$5 million, causing New York Magazine columnist
Kurt Andersen to describe Schwarzman as ‘‘a per-
fect poster boy for this age of greed.’’36 It cannot be
said with certainty that the Levin proposal was
triggered by the lavish display of wealth from a
member of the private equity community, but in
June of the same year (and only weeks before Levin
introduced his carried interest reform bill) Finance
Committee member Chuck Grassley, R-Iowa, along
with Baucus, introduced a bill designed to increase
tax substantially on private equity funds that go
public, by taxing them as corporations. It was
dubbed the Blackstone bill in honor of Schwarzman
himself.37
As Weisbach notes, the comparison must be
made to an individual investor using a margin
account (that is, borrowing money to earn capital
gains).38 Since individual traders pay tax on their
gains at capital gains tax rates and are earning those
gains through wealth and value that they do not
own, why is their taxation not also under scrutiny?
Why is Mark Zuckerberg, founder and CEO of
Facebook, not scrutinized for potentially earning
billions of dollars on stock that has very low (or
zero) basis and is likely to be taxed as capital gains?
Why is carried interest — such a narrow piece of the
concept of capital gains — being attacked on its
lonesome? The simple answer may be that it is
individuals’ level of earnings that is creating atten-
tion, not the basic conceptual economics from
which the income is derived. Arguments surround-
ing the labor required to earn carried interest are
clear (that labor income should be taxed at ordinary
rates); however, the same argument can be made for
an individual investor as well as anyone who earns
their wealth as Zuckerberg has. Scrutinizing a
method of earning income (from a tax standpoint)
simply based on the amount earned is a dangerous
path to take and leads to enormous complexity.
More basic, and more clear, however, is that carried
interest is simply an agreed-on allocation of part-
nership income.
Conclusion
There is much to be considered while discussing
the taxation of private investment in the United
States. Carefully selecting the most important fac-
tors surrounding the matter, without getting caught
up in less relevant motives and analytics, is crucial
to an effective argument. Through all of this one
must consider if fund managers are paying their
fair share in taxes compared with those performing
similar duties, which may very well be personal
opinion more than objective fact, and that consid-
eration should include an analysis of horizontal
equity in taxation.
36
See Kurt Andersen, ‘‘Greed Is Good and Ugly,’’ New York
Magazine, July 22, 2007.
37
Meier, supra note 21.
38

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