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By:  Amanda Wilson

During the second presidential debate, one of the few things that both candidates agreed on was doing away with carried interest as part of their proposed tax changes.  But they never explained what it is.  So what was is carried interest?

Normally, when an employee does work for his employer, the employee includes his compensation in his taxable income at ordinary income rates.  In the partnership area, though, a manager or other person that provides services to the partnership can agree that part of its compensation will be a share of profits.  For example, after the partners receive a specified return of their investment, the manager will receive 20% of any profits over that threshold.  This 20% would be a carried interest.

In the partnership tax world, the receipt of a carried interest is not generally taxable.  Instead, it is only when the partnership actually recognizes and allocates the 20% of profits that the carried interest is taxable to the manager.  Moreover, if the partnership is generating capital gains (common in the real estate area, for example), the carried interest can  qualify for capital gain treatment.

Carried interest has been an easy tax target of politicians for a long time, so it is not surprising to see it targeted by the presidential candidates this time.