	Background

Most private equity and hedge funds are organized as partnerships. The returns of these partnerships are generally taxed as capital gains. It is characterized as ordinary income for the general partner and is taxed at ordinary income tax rates. Character of Carried Interest

Central to the current debate concerning the tax treatment of carried interest is whether it is compensation for services, or an interest in the partnership's capital. In the United States, debate on the appropriate characterization of carried interest has been brought to the forefront by the President's 2010, 2011, and 2012 Budget Outlines, proposed legislation, and a series of congressional hearings on carried interest. 4213 and H.R. 1935 in the 111 th Congress) would make carried interest taxable as ordinary income, whereas a House-passed amendment in the 111 th Congress to H.R. 4213 , the American Jobs and Closing Tax Loopholes Act of 2010, would have treated a portion of carried interest as ordinary income. The former approach may mirror that taken in the 110 th Congress, H.R. 2834 , H.R. 3996 , and H.R. 6275 , in making carried interest taxable as ordinary income. H.R. Under this view, the limited partners agree to finance the carried interest through a reduction (relative to their capital investment) in their rights to the profits of the partnership.
General partners in most private equity and hedge funds are compensated in two ways. First, to the extent that they contribute their capital in the funds, they share in the appreciation of the assets. Second, they charge the limited partners two kinds of annual fees: a percentage of total fund assets (usually in the 1% to 2% range), and a percentage of the fund's earnings (usually 15% to 25%, once specified benchmarks are met). The latter performance fee is called "carried interest" and is treated, or characterized, as capital gains under current tax rules. In the 112th Congress, the President's Budget Proposal would make carried interest taxable as ordinary income. In the 111th Congress, the House-passed American Jobs and Closing Tax Loopholes Act of 2010, H.R. 4213, would have treated a portion of carried interest as ordinary income, whereas the Tax Extenders Act of 2009, H.R. 4213, H.R. 1935, and the President's 2010 and 2011 Budget Proposals would have made carried interest taxable as ordinary income. In addition, in the 110th Congress, H.R. 6275 would have made carried interest taxable as ordinary income. Other legislation (H.R. 2834 and H.R. 3996) made similar proposals. This report provides background on the issues related to the debate concerning the characterization of carried interest. It will be updated as legislative developments warrant.