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Why the Franchise Industry Should Care About Carried Interest

Changing carried interest could impede the private-equity business model.

Some policymakers in Washington, D.C. would have us erroneously believe that moves to change the taxation of carried interest would only affect a handful of hedge fund managers on Wall Street.  When you look beyond the sound bite, however, it is apparent that carried interest is a long-standing and important piece of our tax code that impacts many types of partnerships including those in private equity, venture capital, and real estate, as well as those in the franchise industry. In fact, proposed changes to carried interest could have an outsized effect on franchisees.

Carried Interest is a Capital Gain

To best understand how a tax hike on carried interest hurts franchise investment, it is important to first explain why carried interest is a capital gain.  When people partner together to invest in a franchise, it is commonplace for some partners to bring managerial expertise and operational know-how and for other partners to contribute money to the endeavor.

Partners are free to split proceeds from their investments in whatever manner they believe will yield the best results for their organization.  In many cases, franchise partners look to create an alignment of interests between those partners that bring expertise and know-how and those who invest money to the endeavor by agreeing to provide the partners with expertise a profits interest in the partnership.

A tax hike on carried interest hurts franchise investment.

A carried interest is the ownership, or profits interest, in a partnership held by the investment partner who brings the industry knowledge and management know-how to the partnership.  But why is it appropriately taxed as a capital gain?  The answer is found in partnership law.

A basic tenant of the tax code is that partners are taxed based on the nature of the investment proceeds they receive.  If an investment in a capital asset, such as a franchise, is held for more than one year, all partners are treated equally and rightly receive the long-term capital gains rate when they sell the business.  This is true of partners that contribute capital, as well as for partners who bring to the table their expertise and labor.  So how does this work for franchisees?

Let’s take two cousins partnering together to open a new Carl’s Jr. franchise in Lansing, Mich.  The first cousin has money to invest, but does not have the time or skills to run the franchise.  The other cousin has spent years developing the skills to negotiate a franchise agreement, find a suitable location, hire employees and run a successful restaurant. The cousins agree that the first cousin, who is contributing money, will receive all of her money back plus a preferred return on her investment. After the first cousin receives her money and preferred return, the second cousin with the management know-how will receive 20 percent of the remaining profits from the successful franchise. This is called a carried interest.

Private equity invested $313 billion in companies located across the country last year.

The cousins open the restaurant and run it successfully over a number of years.  There is no question both cousins are owners in the company they started.  Thanks to their hard work and success, when the cousins decide it is time to sell the restaurant, they are able to sell the franchise at a profit.  The tax code treats them both equally by making them each eligible for the long-term capital gains rate.  By fairly treating the contributions of both cousins the same, the U.S. tax code is providing an incentive for investment partnerships to invest capital in new and existing franchises and contribute operational expertise to improve those businesses over time.

Harmful Repercussions

A change to carried interest would not only harm individual franchisees, but could also reduce private-equity investment in franchisors.  Private-equity funds invest in numerous franchisors including Carl’s Jr., Dunkin’ Donuts, Hardee’s, Hertz, Hilton, and many others.  Indeed, many members of the Private Equity Growth Capital Council own prominent franchise companies.  Changing carried interest could impede the private-equity business model, which is responsible for investing tens of billions of dollars into franchises across the United States.

Carried interest is about more than just Wall Street.  It is about private equity, venture capital, real estate and franchise investment in every congressional district and every state.  In fact, private equity invested $313 billion in companies located across the country last year, driving economic growth and strengthening companies for the long term.

Carried interest provides an incentive for private equity to invest in franchisors just as it encourages individual franchisees to take risks and use their expertise to save, start and grow their own franchise businesses.  Franchisees and private-equity investors are true owners in the companies they start and buy.  It is important that the tax code continue to recognize their ownership status and offer these investors and entrepreneurs the same capital gains treatment available to owners of other types of businesses.

Steve Judge is the president and CEO of the Private Equity Growth Capital Council.   He can be reached at 202-465-7700 or info@pegcc.org. 

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