Through a process of Wall Street interpretation of the law and the "Wall Street Rule" (that says that the government tax administration will have great difficulty gainsaying an interpretation of the tax laws that lots of high-powered--read "wealthy"--Wall Street bankers and friends have arrived at for their own benefit), private equity fund and real estate investment partnerships have long operated under the assumption that their managers can earn compensation income as though they were "partners" in the firms they are managing, even though they make no capital contribution whatsoever. This is the so-called "carried interest" treatment of so-called "service partners" who receive a so-called "profits interest" in various types of investment partnerships for managing the assets.
Various commentators, myself included, have long argued that carried interest should be taxed as ordinary compensation income, just like everybody else's compensation for work done. I would go further. The Internal Revenue Code provides for capital interests that are received, in a nonrecognition transfer, for contributions of capital to the partnership. The concept of profits interests is developed in regulations and lower-court case law, both of which could be overturned (as in General Utilities "repeal" when a court case allowing distributiion of appreciated property from corporations without tax to the distributing corporation was "repealed" through a statutory enactment of a provision that required gain recognition) by a legislative restructuring of the partnership provisions to make clear that there is no such thing as a service partner other than one who has made a contribution of equity and who also works for the partnership and receives a "guaranteed income" payment of compensation.
There are many in Congress who recognize the unfairness of the carried interest compensation loophole--not only does an interest that is claimed to represent a portion of the partnership's capital gain income get taxed at a much lower preferential rate than ordinary compensation, but it also avoids all the payroll taxes that the lowliest wageearners must pay. Sannder Levin, a Michigan Democrat, introduced a bill in 2007 in Congress that would have taxed carried interest at ordinary rates. It was defeated by massive lobbying by the private equity, hedge fund, and real estate millionaires (and billionaires).
As Lynn Forester de Rothschild notes in her op-ed in today's New York Times, A Costly and Unjust Perk for Financiers, New York Times (Feb. 25, 2013):
This state of affaires denies our Treasury much-needed revenue; fuels public cynicism in government; and is evidence of the 'crony capitalism' that favors some economic sectors over others.
It is time for Congress to end this travesty. Tax compensation to private equity fund mangers and their ilk as what it is--compensation income for services rendered to investors.