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A US tax court has ruled that managing other people's in an investment partnership is a service and not an investment. Thus, it is likely that the fees paid from the gains from managing an investment partnership is not a capital gain and thus subject to ordinary taxation rates.
Tax Report: 'Carried Interest' in the Cross Hairs - WSJ.com
carried interest is a share of a partnership's profits that is taxed as a capital gain as opposed to ordinary income. It is a good deal: The top rate on gains held longer than a year is 15%, so the tax on carried interest is usually less than half the top 35% rate on ordinary income. There aren't FICA or Medicare taxes, either.
Here is how carried interest works: Say Ted and Joe set up a private-equity fund together. They organize it as a partnership in which they are "general partners" who manage the fund, while their investors are "limited partners." ("Limited" means the investors can't lose more than they put in and aren't in charge.) There isn't a layer of corporate taxes, so profits and losses flow directly through to all partners' personal tax returns.
The typical fees charged by these funds are known as "2 and 20"an amount equal to 2% of the fund's assets plus 20% of its profits.
Organizers like Ted and Joe typically claim the 2% fee as compensation, so it is subject to ordinary-income and payroll taxes. But they usually classify the 20% share of profitswhere the big money can beas an investment that produces a capital gain or loss. ...
Now there is an important voice siding with the skepticsthe Tax Court's. (The Tax Court is a national court devoted only to tax cases where taxpayers needn't pay disputed levies up front.) The ruling in Dagres v. Commissioner wasn't directly about carried interest but contains an important ruling on it that experts are now parsing.
Venture-capital-fund manager Todd Dagres wound up in court over a $3.6 million deduction he took for a loan to a business associate that went sour. From 1999 through 2003, Mr. Dagres earned $10.9 million in compensation and $43.4 million in capital gains from carried interest.
The case hinged in part on whether Mr. Dagres's share of profits meant he was engaged in a trade or business, or was acting as an investor. The Internal Revenue Service said he was an investor, but in late March the Tax Court disagreed and allowed Mr. Dagres to have his deduction because his carried interest was compensation from a trade or business.
Wrote Judge David Gustafson: "Neither the contingent nature of [Mr. Dagres's carried interest] nor its treatment as capital gain makes it any less compensation for services." The opinion also likened his business to that of "stockbrokers, financial planners, investment bankers, business promoters, and dealers"all of whom pay taxes on their income at rates up to 35%.
Tax Report: 'Carried Interest' in the Cross Hairs - WSJ.com