Financial analyst and certified public accountant Daniel Mazzola explains for Barron’s readers why carried interest doesn’t deserve its bad rap.

Let’s look at the topic from the point of view of two small-town, small-business ventures.

First, Jake owns a newsstand. His is a thriving business, and he is looking to make it grow by selling mobile phones. One of his daily customers, Tom, has been impressed by Jake’s industry and operational efficacy since he first encountered Jake running a lemonade stand when Jake was 9 years old. He has been helping him quietly ever since, and now Tom offers to lend Jake money to expand his business.

Jake’s expansion is successful, and Jake sells the newsstand after two years for a sizable gain, paying off Tom’s loan with interest, and of course paying capital-gains taxes.

Jake and Tom enjoy working together and are ready to move on to another project. Their activity will be restoring a neighborhood theater that has fallen on hard times. Tom will again be the financier; Jake will handle the day-to-day affairs of rebuilding and managing the theater to enhance its value. This time they will be partners.

In the new business arrangement, Jake receives wages for his daily services, and the two agree that he will collect a share of the sales proceeds if the business is sold after at least a year of operation and if the profit on the sale exceeds a specified threshold.

The profit on the sales of the newsstand and theater should be recognized for tax purposes as a long-term capital gain. The fact that Jake operated alone as a borrower in the first enterprise and as a partner in the second has no bearing on the fact that they both were capital gains. It also is irrelevant that Jake did not invest his own money in the theater renovation. With regard to partnerships, the tax code does not distinguish between financial capital and “sweat equity.”

Jake will pay ordinary income tax on his compensation as the theater manager. Jake’s share of the profits when the theater is sold for more than a hurdle rate that was specified in advance is known as carried interest, and Jake will pay the capital-gains rate on it.