The carried interest tax is back on the table in the Obama administration’s budget proposal for fiscal year 2012, released early last week. If adopted, the proposal would tax carried interest at ordinary income rates (up to 35%), rather than at the capital gains rate (up to 15%). A similar proposal was introduced in 2010, but failed to gain traction in the legislature. The Obama administration estimates that a change to the carried interest tax rate would increase tax revenue by $14.8 billion over the next 10 years.

The carried interest tax rate is a critical consideration for private equity and venture capital fund managers, as it is often the fund manager’s primary source of income. Fund managers typically receive two streams of income, management fees and carried interest. Management fees earn 1-2% of assets under management, while the carried interest can amount to as much as 20% of the profits of the fund. The fund manager begins to earn carried interest after the fund has returned the original capital contributions of the investors, plus a priority return on those contributions (referred to as the “hurdle”). Once the fund manager has achieved the hurdle, additional fund profits are divided 80% to the investors, and 20% to the fund manager. [Read more...]