Carried Interest: prospects?
by Linda Beale
crossposted at Ataxingmatter
Carried Interest: prospects?
At the ABA Tax Section meeting in Washington last weekend, there was surprisingly little talk about the carried interest proposal. Carried interest, for those who don’t work often in the partnership area, is the way that managers of real estate, hedge, and equity partnerships receive a generous payment for managing the fund–usually a “2 and 20” 2% of the assets under management annually and 20% of profits fee for services. The 20% is claimed to be gains from asset dispositions rather than services (providing a preferential rate in some cases, as well as no payroll taxation) and often has been deferred through offshoring.
Various tax experts have called for taxing both the fee and carried interest as ordinary compensation subject to payroll taxes and always taxable at ordinary rates. That proposal has been suggested in Congress at various times as a revenue raiser, but it has not yet been enacted as part of a bill, since the Senate has not included the House-passed version. The Real Estate Roundtable has lobbied strenuously against the carried interest provision in past years and successfully joined with private equity, hedge fund, and venture capital firms to defeat the idea.
There is talk now of including it in the jobs bill that Congress hopes to pass before the end of May. See Real Estate Group PUshes to Soften ‘Carried Interest’ Tax Rise, Bloomberg, May 8, 2010. Naturally, lobbyists are busy trying to eliminate or modify the provision. The head of the Real Estate Roundtable noted that the group is arguing for a “blended” tax rate that would provide a rate between the capital gains preference and ordinary rates, or a provision that would apply the capital gains rates for gains from investments that the partnership holds for at least 2 years. A spokesperson for the National Venture Capital Association siad that “we’re not accepting this as a fait accompli…we have not waived from our position.” Id.
The argument for taxing the carried interest of “profits” partners as compensation income, however, is strong: there is little justification for further complicating the Code with blended rates or a new long-term holding period for the capital gains rate. These managers should pay tax at ordinary rates and should also be liable for the ordinary payroll taxes on their full compensation income. Sure, they won’t like it and they “won’t waiver” from trying to push the Senate to ensure their cozy deal. But that is not a satisfactory argument for failing to make this change which is required for fairness’ sake.
(2 and 20 corrected by Rdan)
Linda,
Could you explain the ‘2 and 20’ a little more? Does “20% of the assets under management annually” mean the fund manager is paid 20% of the funds he controls (thus if manages $100M they pay him $20M every year?) I know I’m missing something here or I’m really not in the right line of work….
Islam will change
A typical manager may charge fees of “2 and 20“, which refers to a management fee of 2% of the fund’s net asset value each year and a performance fee of 20% of the fund’s profit.
The argument for taxing the carried interest of “profits” partners as compensation income, however, is strong: there is little justification for further complicating the Code with blended rates or a new long-term holding period for the capital gains rate.
The code needs to be further complicated by enacting your proposal. The “simplicity” of the code as it relates to this, is defining the character of income, which for Private Equity, Real Estate, and Timber partnerships is Capital Gains.
The deferral issue related to hedge funds is real, but should not be confused/conflated with the carried interest topic – it’s a completely separate matter.
Payroll taxation – at least as it relates to OASDI – is also irrelevant because most base salaries in the industry for employees that earn a share of carry are above the threshhold for OASDI. Where it matters is for Medicare tax (which was changed by Clinton to remove the ceiling, and I believe Obama has proposed to apply Medicare tax to capital gains, so it won’t matter in that case either)
Slightly odd argument. The 20% is from profits. So why isn’t it to be taxed as a profit, why should it be taxed as income?
Thanks!
But that still means your fund manager needs to make at least 3.5% per year just to cover his fee and taxes so that you still have your original capital. Then add inflation to that…
Islam will change
Worstall –Because it is a “FEE”.
Moreover, it is not the profits of the manager who receives it, it is their compensation.
It is the profits of the investor in the fund who does not get carried interest and that investor probably is already paying a lower tax rate on their profits.
Spencer,
I’m sympathetic to the “compensation” argument, but. . .
Consider a situation where you have capital and your brother has labor skill in managing a book store but no capital. You each take a 50% equity stake in the new book store he opens, you as a passive investor and he as management. He gets paid a salary for managing the store. 5 years later you sell it to Borders at 2x your original investment. You as the capital would get capital gains treatment on your 50% and so would your brother on his 50%.
Now use a similar situation, but instead of brothers, have it with two people who don’t know each other, but find each other through a third-party intermediary. You take 40% for your capital, the manager takes 40% for his labor, and the intermediary takes 20% for the labor of putting the two of you together. When the business is sold, the character of the capital gain doesn’t change simply because there’s an intermediary that owned 20% of the equity.
(FWIW, I do not currently, nor ever have, worked in an industry where a portion of my income benefits from the “carried interest loophole”)
Explain how the capital gains profit deserves to be continued as a special class of income deserving of taxation at a lower rate than is earned income. This is the most obnoxius aspect of the tax code though close to the dividend income and inheritance preferred rates of taxation. They’re all income and the sooner the tax code treats all income in the same manner the better for the country in general. And the codes then become so much less complex. Why should it cost more to work for wages than to be paid to manipulate assets?
“Explain how the capital gains profit deserves to be continued as a special class of income deserving of taxation at a lower rate than is earned income. “
Oh, that’s easy. Income comes without risk. You go do that, you get paid. Capital income comes with risk. Maybe it’ll work, mebbe it won’t. Thus the tax rate is lower for those who have taken the risks to get the income.
After all, we do want people to take the risk of setting up new businesses, looking for new things to patent, new ways of doing things, new companies….don’t we?
I am a little confused and maybe Linda can help. What is the theory of taxing the 2% at capital gains? I can at least understand the argument for the “disposition of assets”, but I can’t get my mind around the 2% portion at capital gains rates.
The 2% isn’t taxed at capital gains rates.
Timmy,
You’re not even close. The only rationale offered by the tax “experts” is that gains that are long term are themselves reduced by inflation. Therefore the lower rates. At least that’s the rationale which would make some little bit of sense if the break point was ten years. It’s not.
More like 18 months, but I forget the exact time period for long from shrot term.
The difference between risk income and work income is strictly ideological and has no place in the tax codes. Lately the “risk” is beginning to look a lot more like manipulation. Big banks seem to have taken the risk out of the trading game:
http://www.nytimes.com/2010/05/12/business/12bank.html?scp=1&sq=proprietary%20trading&st=Search
Thanks