One of the most unfair income tax breaks is the 15% tax on carried interest. Carried interest is a profit sharing bonus that is received by private equity and hedge fund managers, and general partners in real estate limited partnerships. Carried interest bonuses are taxed at the favorable 15% capital gains rate on the theory that the manager has his own money invested, and the bonus is part of the capital gain on that investment. The theory is wrong. Capital gains on money invested are divided among investors based on the amount of their investment. To the extent that a manager is also an investor, he receives capital gains just like all other investors. Carried interest is an additional bonus paid above and beyond any return on money invested.
For example, a hedge fund manager might get a carried interest bonus of 20% of any profits that are above a 10% return to the owners. If the investment earns 15%, the bonus would be 20% of the extra 5%. After payment of the bonus, the net return to the investors would be 14%. If the manager is also an investor, he would receive the 14% return on his investment just like all other investors and would pay capital gains tax on the profit just like all the other investors. The carried interest bonus is an extra payment based on performance. In any other business the extra payment would be called a bonus and would be taxed as ordinary income. The fact that the manager is also an investor should not change the bonus payment into a capital gain.
Those who receive carried interest payments will fight tooth-and-nail to keep the tax break. They might even make political contributions to those they wish to influence. But politicians need to step back and see these payments for what they are: bonuses that should be taxed just like all other bonuses – as ordinary income.