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Wall Street's Lucrative Tax Break Is Under Fire

Twenty years later, a tax court issued a similar opinion in another case, which was quickly overturned on appeal. Since then, the IRS has tinkered on the edges of the issue. The agency declared in 1993 that the award of a profit share to a partner in exchange for services would not be immediately taxed.

But neither the agency nor the courts have addressed the question at hand: When the profits eventually do roll in, should the service partner be taxed in the same way as the investors?

University of Texas law professor Mark P. Gergen, who has written in favor of changing the Carry's tax status, said that until now, "nobody has been focusing on the fact that if you're contributing services to a partnership where the returns are capital gains, you've managed to convert ordinary income to capital gains."

Advocates of change say there is ample reason to identify the Carry, or at least most of it, as a wage. It is, after all, not a return on invested money. It is the product of work done to help a venture succeed, in much the way that an assembly-line employee helps a company make cars or airplane parts, they say.

"These investment managers are being paid to provide a service, and fairness requires they be taxed at the rates applicable to service income just as any other American worker," Levin said.

Defenders of the current system say Levin misreads the situation. They say managing partners are not employees, but bosses, deserving of the capital gains income that flows through the partnership because they are largely responsible for creating it.

"The general partner should be treated as the owner-proprietor because he raises the capital from the other partners and controls all decision-making," said Jonathan Talisman, a lobbyist retained by the Private Equity Council, the trade association of the private-equity industry. "We reward this type of entrepreneurial risk-taking and investment in long-lived assets with favorable capital gains treatment."

Congressional tax-writing committees plan to tackle the Carry this fall and to consider the narrower Senate bill that would force publicly traded private-equity firms and hedge funds to pay taxes at the 35 percent corporate rate.


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