There Is No Bright Line on Taxing Carried Interest

If you run a venture-capital or private-equity fund, you invest money on behalf of other investors. You have to pay for rent, benefits and wages for your employees and yourself, so if investors give you $1,000, you charge 2% ($20) to pay your expenses. You don’t get rich on fees unless your fund is enormous. Venture capitalists and private-equity investors are willing to enter this profession and put in effort because they get to keep a fraction of the profits on the investments—the fees merely keep the lights on.

If the $1,000 investment becomes $2,000, 80% of the $1,000 profit goes to investors, and you keep 20%, or $200. That’s carried interest. The wages you earn from fees are taxed as ordinary income, but your share of the appreciation of the company’s value is taxed as a capital gain.

This is different from buying stock because venture capitalists don’t put in their own money but rather their time and effort—“sweat equity.” The argument for taxing that $200 as ordinary income is that it’s a return on labor, not capital.

But suppose you open a restaurant, struggle at first, and pay yourself minimal wages because it isn’t yet profitable. When it becomes profitable, you sell it. The sale price minus the initial investment is taxed as a capital gain. That’s a return on sweat equity too, yet no one in Washington is suggesting that when small-business owners sell their businesses for a profit, they should be taxed at 40% rather than 20%.

The tax code draws bright lines between things that lie on a continuum. No matter where one draws the line, something is just above it and something else is just below it—and because the differences are small, the distinctions will look unfair to some people. That’s why we can be sure the debate over carried interest isn’t over.

Mr. Petersen is a professor of finance at Northwestern’s Kellogg School of Management and director of its Heizer Center for Private Equity and Venture Capital.