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In Defense of Carried Interest Tax Treatment

New York (HedgeCo.Net) -By Andrew Lerner, Managing Partner, IA Capital Group.

Private equity professionals, venture capitalists, real estate investors and hedge fund managers share in the appreciation of the assets they manage, in the form of carried interest. Controversially, carried interest is taxed as capital gains, and not ordinary income, for federal income tax purposes. On the other hand, in most states where it is earned, including California and New York, carried interest is taxed at ordinary income rates. In addition, starting in 2013, a Medicare tax of 3.8% applies to both capital gains and ordinary income of high-earning individuals. Including the Medicare tax, the maximum applicable federal rate on carried interest is 23.8%, up from 15% when President Obama took office, plus up to 13.3% on the state and local level.

Is this current tax treatment of carried interest fair? I will try to put my self-interest aside and let the facts speak for themselves.

In a time of rising income inequality, it is certainly reasonable to argue that the wealthiest taxpayers should be subject to higher tax rates. There are also rational arguments that capital gains should be taxed at the same rate as ordinary income. But neither of these positions appears to have any chance of passing Congress any time soon. Instead, hoping to narrow the income inequality gap, many intelligent people have focused on the subset of affluent individuals that earn carried interest, for what appears to be pragmatic and symbolic purposes. Pragmatic because a change to carried interest tax treatment might actually pass Congress; and symbolic because hedge fund managers have become poster boys for global income inequality.

If, as a matter of principle, you believe all wealthy individuals should pay more in taxes, you probably won’t care about the substance of the debate surrounding carried interest. But a change to a very specific part of the tax code should be influenced by facts and not philosophical beliefs. Since wealth and carried interest are not synonymous, the debate about carried interest tax treatment should not be about income inequality.

In order to determine whether carried interest is treated fairly within the context of the tax code, let’s ask the hard questions.

Is carried interest compensation or a capital asset? The honest answer is that it has elements of both.

Carried interest is usually something you earn, but it is always an asset you own. Legally, ownership is determinative, while employment is irrelevant. For example, Mitt Romney hasn’t worked at Bain Capital since 1999 but still receives carried interest. I can sell mine to you. There’s an excellent argument that appreciation on my home, my investments, my business, or my fund’s investments should not be considered compensation if I own them, regardless if I funded them with borrowed money. The reality is carried interest is part compensation and part capital asset, and is taxed as such: as a capital asset for federal income tax (capital gains rates have been raised substantially in recent years) and as compensation under most state income tax codes.

Similarly, is carried interest a fee for service rendered? It depends on your point of view, since a fund manager is both a service provider and a business owner.

When other business owners raise capital by selling an 80% ownership stake, the 20% retained is certainly not a fee for service. It’s not much different when a private equity firm owner sells an 80% ownership stake in a fund’s gains and retains the 20% carried interest. The limited partners in my firm’s funds can be viewed (i) as clients paying a fee for service or (ii) as investors that are sharing in the gains of our investments. Both are correct.

Is most of a manager’s income from carried interest? No, management fees are usually more significant.

While the media focuses on a handful of successful firms with outsized carried interest gains, the typical manager makes more on management fees, which are taxed as ordinary income. And quite a few managers have never received a dime of carried interest.

Besides fund managers, who works for asset appreciation? Everyone who owns a business, from the start-up entrepreneur to billionaires.

Most entrepreneurs work not for wages but to build a business. Oddly similarly, billionaires such as Mark Zuckerberg and Larry Page earn salaries of $1 per year. Perhaps the tax code should prevent all business owners from enjoying capital gains rates on the fruits of their labor, but there are no strong arguments to single out fund managers from other business owners. There is a fallacious argument that, since fund managers invest only 2% of the capital but enjoy 20% of the gains, they are different from traditional entrepreneurs. The fact is all successful entrepreneurs with outside investors enjoy an ownership percentage in their business that’s larger than their pro rata share of paid-in capital.

Is there a downside to carried interest? Absolutely.

Starting a new fund management firm today means working for free during a fundraising process that can last two years or more. In order to form a new fund and potentially benefit from carried interest, an aspiring manager needs to risk up to a million dollars of out-of-pocket start-up costs. And, by the way, fundraising costs are difficult to deduct. Unsuccessful business owners in other industries at least get a tax deduction.

Isn’t carried interest similar to an employee stock option, which is earned income? No, a stock option grant has no downside risk.

On the day I incorporated my venture capital firm, what was the carried interest worth? Arguably, it was worth less than zero. In other words, the costs and uncertainty of raising my first venture capital fund outweighed the potential future benefits of carried interest. Unlike a stock option grant which does not put the grantee’s money at risk, carried interest requires an upfront investment by the firm’s founders. Essentially, carried interest can be viewed as a capital asset with a negligible tax basis. This is proper tax treatment for all start-ups; even if Warren Buffett were to incorporate a new company, he would be permitted to own it with a near-zero tax basis.

Is carried interest only available to the rich? Absolutely not.

Typically, firms make carried interest available to most or all of the professional staff. Lower-level employees benefit, including thousands of individuals with negative net worth (i.e. more student loans than assets).

Can other workers get the low tax rate that carried interest enjoys? Yes, but it means foregoing cash compensation.

Every employee is permitted to be compensated with stock, but few people want to be paid with anything other than cash. If they did, they would enjoy the same capital gains tax treatment. David Choe is a graffiti artist who chose to be paid in the stock of a start-up. That start-up was Facebook, and his stock ended up being worth a reported $200 million. After establishing a minimal basis, Choe owed capital gains tax rates on his windfall, just like the Facebook venture capitalists.

Do fund managers pay lower-than-average tax rates? No, most pay higher rates.

The people that claim hedge fund and private equity executives pay low rates ignore the fund managers that don’t receive significant carried interest. And they ignore state and local income taxes, as managers usually live in high-tax areas like New York City. And they ignore all the tax advantages that reduce rates for the average worker, such as deductions for health insurance and retirement plans. Without a doubt, the median-earning fund manager is subject to a higher all-in tax rate than the median-earning American.

If carried interest were taxed at ordinary rates, would fund managers be taxed the same as other business owners? No, since fund managers are disadvantaged in other ways.

The Creating Small Business Jobs Act of 2010 granted a 0% capital gains rate to small business owners who invested in their businesses through 2013, except that financial and professional services firms (including all fund managers) were excluded. The 0% rate is not a typo. Sell your hedge fund management company after five years, pay full capital gains taxes; sell almost any other small business after five years, pay no taxes. This tax treatment, section 1202, is never mentioned by people who supposedly want to equalize tax rates of fund managers with other industries.

Is carried interest a tax loophole? No, the word “loophole” is a subjective term that doesn’t belong in a fact-based analysis.

Is carried interest a loophole because it takes advantage of an ambiguity in the law? No. Congress has been aware of the tax treatment for decades and has conspicuously not altered it. Is it a loophole because it’s not taxed as ordinary income or because it was once obscure? No. Medicare benefits are not taxed at all, and 401(k) plans were once obscure. If Medicare benefits and 401(k) plans are not tax loopholes, than neither is carried interest. And what about the obscure tax law that allowed President Obama to avoid declaring his million-dollar Nobel Prize award as income? If carried interest is a tax loophole, how could that not be?

Are private equity profits an important source of lost tax revenue? Yes, but the lost tax revenue is from the 80% of gains that go to outside investors, not the 20% that go to fund managers.

Managers are subject to up to 43.4% federal tax on management fees and 23.8% on carried interest, plus up to 13.3% state tax. On the other hand, many (perhaps most) institutional investors such as pension plans, endowments and foreign companies pay no US income taxes at all.

If you believe the wealthy should pay more taxes, that’s perfectly reasonable, but the facts do not call for singling out carried interest.

By Andrew Lerner,
Managing Partner, IA Capital Group
andy@iacapgroup.com

 

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