This Note starts from the premise that preferential capital gains treatment presupposes actual invested capital. It argues that a carried interest comprises an aggregation of income from services and income from invested capital and that each respective component should be taxed accordingly. This Note introduces the mathematical bifurcation model for disaggregating a carried interest into its service and investment components, representing the first rigorous attempt to distinguish those components mathematically. It demonstrates that the current debate over the taxation of carried interests is largely conjectural, because each side focuses myopically on arguments with little foundation in tax theory. Taking assumptions most favorable to the taxpayer fund manager, including unusually high growth rates in longer-term funds, mathematical bifurcation indicates that, as a theoretical matter, the service component of a carried interest exceeds—by several multiples—the component from actual invested capital. This Note does not seek to provide a practicable alternative for taxing carried interests. Rather, it aims to offer a theoretically superior starting point for the carried interest debate, derived from the premise that only income from actual invested capital should receive preferential capital gains treatment.

 

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