Carried Interest: some senators want venture capitalists to get a CG ride on their compensation income
by Linda Beale
crossposted with Ataxingmatter
Carried Interest: some senators want venture capitalists to get a CG ride on their compensation income
Everybody knows by now that managers of partnerships who have “profit interests” have been claiming that they do not have compensation income but merely a return of capital on their “carried interests” (and that may be long-term capital, they claim, when they hold the profits interest for some time and there are long term gains in the partnership that are allocated to them).
Many tax experts, including myself, have argued that these profits should be taxed as compensation. At ordinary rates, like the janitors and clerks and other employees of the firm. Immediately and without deferral, like others who work for a living. And subject to payroll taxes (FICA, FUTA), since wages are supposed to be subject to payroll taxation.
Managers of private equity, hedge, venture capital, real estate and other partnerships have been able to avoid such real world consequences of working for a living in most part. They are generally paid a fee (usually about 2% of assets under management, in hedge and private equity firms) and a “carried interest” (usually about 20% of assets under management, each year, and sometimes amounting to 30% or 50%, for the really big-time managers). They do treat the fee as compensation, but claim that the carried interest is not.
Congress is finally quite likely to pass a bill that will treat carried interest as the compensation that it is. So of course each type of partnership management is lobbying for an exception for itself–tax the others, but I’m so important that you ought not to tax me because continuing to give me this incredible tax break will keep me doing this really important stuff.
That line is garbage. These managers generally make kaboodles of money. They will still do the work and making kaboodles of money even if they have to pay taxes more like ordinary employees.
But some senators seem to be falling for this crappy argument. For example,Republican Scott Brown of Massachusetts and Senators Patty Murray of Washington, Mark Warner of Virginia, Bob Casey of Pennsylvania and Jeanne Shaheen of New Hampshire want to exempt venture capital firms from the change in the treatment of carried interest. The claim boils down to saying that if you tax these managers on their compensation like you tax “regular” workers, it will hurt the work that these venture capital firms do in encouraging entrepreneurialism. See Donmoyer, Senators Seek Venture Capitalist Waiver from Fund Tax Increase, Bloomberg.com, May 13, 2010.
Can these senators really think that taxing the worker will make the managers stop managing billions of dollars?
Lobbying is underway. Listen, Congress, to your head and not your pocketbooks. Managers of partnership perform services and get paid for those services. All of that payment should be treated as compensation, be taxed at ordinary rates, and be subject to payroll taxation. To do otherwise is to let very wealthy people off the hook for their share of the tax burden, and to impose a greater tax burden on everybody else–especially on the little people.
Can the voters put two and two together to realize that any senators who end up supporting an exemption for the real estate industry or the venture capital industry (or any other industry) are more worried about losing the support of big money than they are about ensuring that big money managers pay taxes fairly just like so many ordinary American workers do?
And if you are wondering whether firms like hedge funds and private equity funds–significant parts of the “shadow” banking system–add real value to the economy, you might enjoy this article by Harlan Platt about private equity, The Private Equity Myth. Download Platt. The Private Equity Myth.
Every time someone makes a claim that they are so important that they deserve special treament I note that we find out are are most importtant everytime they go on strike in New York City (or any big city): the garbage collectors.
The other error in the thinking regarding how important something is to the “economy” relates to the chicken and the egg. Who cares which came first. You need both and that makes them equally first.
Carried interest is paid from the profits of deals. Deals do not make a profit, there isn’t that 20% for people to be paid. So it’s not a fee for work, it’s a fee for having generated a profit…and givwen that that profit generated is itself a capital gain then it’s much more like a capital gain than it is income.
And yes, it really is necessary for them to create a capital gain to get that 20%….there are innumerable hedge funds which lost money over the last couple of years. And their managers will nto be getting 20% of those non existent gains. Indede, they won’t get any until those hedge funds have both made back the losses and then made further profits.
This is much more like a capital gain than it is income.
Well if THEY didn’t put the capital in, it really isn’t a capital gain for THEM. It resembles a comission or bonus more than it resembles wages, but it resembles a return on THEIR investment hardly at all.
Sorry Tim, carried interest is paid from the income of the investors in the fund.
You keep making the same argument over and over again,
and I’ll keep pointing that that it is factually incorrect.
Spencer, I’m pretty sure your description is not the way the contracts are written. I believe after a hurdle return, the client (LP) shares 80/20 proportionally with the investment manager (GP) on the gains. Except, I think, the GP has an ownership interest in the LP vehicle. The money is not handed back to the LP and then round-tripped back to the GP.
When Brin and Page took Google public what was the cost basis of their Google stock? I’m guessing it rounded to zero. Kleiner Perkins or Sequoia or whomever the VCs were, were intermediaries for CalPERS, GM Pension, Harvard Endowment, etc, who put up the investment capital. The investment capital had a cost basis that was something north of zero depending on the valuations at the times of funding. So what is the cost basis of Kleiner Perkins?
I’ll also reiterate – Linda, Tim, whomever, please stop conflating Private Equity carried interest gains with hedge fund carried interest gains – they’re very different and for most “traditional hedge funds” (e.g., long/short equity) gains are short-term in nature (< 1 yr) and wouldn't even have the opportunity for cap gains treatment if they did this as practice, which they don't.
How about the tax codes stop fostering the BS that some income is different than other income.
Then all the geniuses can stop their mental masturbation concerning what income is capital gains, what is earned income what is dividend income, etc. It’s income that comes in each year. If an asset is held over time, when fianlly sold there may be income that has been deferred over that period of time, but it’s still income. Why the diferentiation of one form of income from another?
The government helped all of us to have a safe and stable environment to work in. That same government protected everyone’s assets and provided a legal structure that allowed for the various types of market activities that rtesulted in income for many people. Our taxes help to cover the cost of maintaining those helpful government activities. Be patriotic. Pay you taxes and stop this BS about one form of income being favored when it comes time to pay one’s taxes. It would certainly help if the legislative members of our government would stop favoring the interests of the very wealthy over those of the just plain working stiffs of our country.
Jack, there’s actually a very good reason to tax capital gains at a lower rate than wages. Most capital gains are earned over long periods of time, and they are taxed based on the nominal gain. If capital gains were inflation adjusted for tax purposes, you could make a legitimate argument to tax them at the same rate as wages (and short-term gains). But then we’d have to agree on a CPI measure for determining the real value of the gains, which is never going to happen…
That’s the line we’ve been handed for years now. Adjustment for inflation my butt. All income is reduced by inflation over time. Workers in America have seen very little income gains over the past several decades, but inflation marches on and our tax rates don’t benefit from any “adjustments” to make up for the loss to inflation. What about those periods of time when inflation is at a lower level than the years before? Does the CG rate go up when inflation is low? Please, that’s another part of the BS aspect of the tax codes. All income has the same purpose, spend or save. Tax it all as income. Set the rates to reflect the greatest benefit from our economy. Those who have enjoyed the greatest benefit should pay the greatest share.
Jim, I’ve used this over and over again to explain why it’s currently considered a capital gain:
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, on which he pays ordinary income taxes, FICA, etc. 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 your brother would owe no taxes (your basis would be 1x, your gain would be your 50% stake of 2x)
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.
Workers in America have seen very little income gains over the past several decades, but inflation marches on. . .
I’m pretty sure the data you’re drawing this from already adjusts for inflation.
. . .our tax rates don’t benefit from any “adjustments” to make up for the loss to inflation.
Not true. Federal income tax bracket thresholds are indexed to inflation.
The other argument for different treatment of cap gains income, aside from inflation, is that capital is much more fungible than labor, and can readliy move in search of the highest after-tax returns – regardless of your views on its patriotism (or lack thereof).
I am gonna disagree with your comment on labor loss in income due to inflation. The loss comes from productivity gains being skewed towards capital instead of labor. To your other point, the highest returns to date have come from capital gains or what I would term as “asset appreciation.”
The S&P500 – as cactus or spencer are wont to point out – has been basically flat for a decade in nominal dollars. Nonfarm labor productivity grew about 2.7% from 2000-2009 vs. 2.1% from 1990-2000 (http://bls.gov/lpc/prodybar.htm). So productivity gains haven’t found their way to equity owners (capital).
From the Fed’s Survey of Consumer Finances, median real family income cumulative growth from 1998-2007 (survey conducted every 3 years, so you can’t line up decadal info, 2007 latest available) was 11%. But the 10th percentile and 30th percentile (median of each bottom two quintiles) outpaced the 50th percentile at 18% and 12%, respectively.
Finally, to the best of my knowledge productivity is calculated on an average basis and there is no stratification of the data. I’d suggest that just as there exists income inequality, wealth inequality, debt inequality, there also exists productivity inequality.
I’m not clear on the point your making about “asset appreciation”, especially since it seems at odds with your prior sentence. If productivity gains are being created, and you believe they’re skewed towards capital, then assets should appreciate.
Maybe you didn’t see it; but Spencer did do a nice report on “Labor’s Share detailing the skewing of productivity gains towards capital. here is one chart which may interest you. http://2.bp.blogspot.com/_Zh1bveXc8rA/SuddUhLWUaI/AAAAAAAAA7M/iU2gefk317M/s1600-h/Clipboard01.jpg
The gains you portend to labor haven’t shown up in Household Median Income and we have remained relatively flat since 2001 . . . inflation included. Here is a spencer quote:
“it will be interesting to see how the libertarian and/or conservative analysts who keep coming up with all types of excuses to explain away the weakness in real labor compensation in recent years explain this away”
and an affiliated chart on profits: http://4.bp.blogspot.com/_Zh1bveXc8rA/SuiGsMYdZ7I/AAAAAAAAA7s/F6jjMdO3YY8/s320/Clipboard01
Do you really believe labor income has grown over the last decade after considering the numerics of the numbers of people in Not In Labor Force and Unemployed. I will even go as far to say the numbers existed to keep labor wage in control up to the present recession.
There is nothing wrong with my statement on asset appreciation except your conflation of it
The gains you portend to labor haven’t shown up in Household Median Income and we have remained relatively flat since 2001 . . . inflation included.
Citation please. I’ve already cited the Fed’s Survey of Consumer Finances. From 2001-2007, in 2007 dollars, median family income increased from $46.9k to $47.3. According to the Current Population survey, median household income in 2008 dollars declined from $51.4k to $50.3k (http://www.census.gov/hhes/www/income/histinc/IE-1.pdf), but this is not a case of “the rich getting richer” as income at all percentiles shown except for the 90th fell from 2001-2007, with the 90th growing $111 dollars (real).
I wasn’t trying to conflate your statement, I honestly don’t understand the point you’re trying to make. In what ways are capital gains generated without asset appreciation? All else equal, if I can get an 8% return in a 20% tax environment, I’d prefer that to a 10% return in a 40% tax environment with a 1-year horizon. Assuming the capital gain isn’t taxed until realized, these 2 scenarios eventually balance with tax-free compounding and at some point favor the higher tax regime.
But the brother IS receiving his 50% stake in exchange for managing the store, NOT as a return on capital. Really that 50% stake IS part of his compensation for the work of managing the store. Now you can make a reasonable argument that the 100% gain on his 50% stake is a capital gain, but ONLY if you tax that 50% when it is received as ordinary compensation. If you’re not putting in capital, it can’t really be a capital gain, it’s compensation.
Jim, thought you may say that . So now extend the analogy, where the brother instead of sharing his equity stake with a third-party capital provider, takes out an interest-only loan from a bank for the capital he needs. When he sells the business, he owns 100% of the equity at zero basis, but has to pay off the bank half of his proceeds from the principal on the loan. His taxes are no different than the first analogy I used.
Does the loan count as “compensation” at origination, therefore subject to income taxes? And if so, doesn’t that mean when I take out a mortgage, you’d argue that is also compensation?
Your logic also would require venture founders (not the capitalists) like Brin & Page to pay ordinary income tax on each round of funding, rather than capital gains as they’re selling off portions of their equity. Are you taxing the past or the future value creation?
In the venture capitalist example, the initial 40% that the manager receives should be taxed as income because it’s still COMPENSATION for for managing the business. The 20% that the broker gets is payment, and at the end of the year, if he has turned a profit should be taxed. Again, the future appreciation is a capital gain but the initial payment is not. Why should these forms of compensation and payment be treated differently than any other in kind payments just because they might appreciate in the future?
I’m not arguing against the very existance of capital gains. And yes, to the extant that venture founders are rewarded with new equity stakes (I’m not sure how common this is) that should be taxed at that time. Just because you’re compensated in equity stakes (stock) doesn’t mean that you shouldn’t pay income taxes on it. If your company receives equities as a payment, those should be counted towards profits. Valuation can be an issue, especially for a company whose stock isn’t traded. But in the first example, it’s fairly easy to assert that each brother’s 50% is worth the same amount. Whether you value it at COST or liquidation value is a question for deeper minds than mine.
m.jed and run,
You see, you both can make reasonable arguments for one point of view vs the other. The solution to the issue, since the arguments can’t be definitive one way or the other, is to stop monkeying around with definitions of income that benefit some tax payers over others. It’s income. Tax it. Stop BSing about diferent kinds of income being one thing or another.
m.jed, I love your distinction of the two kinds of income, from gains and from labor. “The other argument for different treatment of cap gains income, aside from inflation, is that capital is much more fungible than labor, and can readliy move in search of the highest after-tax returns.” Of course you’ve failed to explain why that should make a difference in tax rate, but it is a perfect example of how any distinction can be argued in favor of without any reasonable explanation. It’s all income. Tax it all alike. Those who gain the most from our economy owe the most back to the government that provides the structure for that economy and the plrotections to that economy.
Oh please, the 10% of the tapayers is a conflation of what the 1%, and for that matter what the 3%, actually did in income and how they did it. Looking at the 10% which is ~$125,000 as derived from here: http://www.taxpolicycenter.org/numbers/displayatab.cfm?DocID=2419&topic2ID=40&topic3ID=41&DocTypeID=1 You are averaging out what the higher incomes did with people who made far less in income. The average income for those making > $1MM is ~$2.8MM and those making between $500M and $1 mm is ~$680M (same chart as shown. Do you really believe much of this is payroll wages?
Jed, nuts to your citations, the average increase in income because of the income tax cuts was $120,000 annually for those making greater than $1MM, $45,000 for the 1 percenters, and ~$5700 annually for the top 20% of taxpayers. I suspect the bottom of that 20% was far less than the $5700. http://www.cbpp.org/images/cms/9-27-06tax-f4.jpg and here: http://edgeofthewest.wordpress.com/2008/12/16/whos-afraid-of-the-big-bad-poor/ You are hiding the true increases in the numbers of the taxpayers.
As you show, Household Median Income increase (sigh) a paltry $400 as measured against what the 1 percenters did in increased income due to tax breaks alone . . . $45,000? Again you are conflating the issue of income. And we haven’t even touched upon what portion of that income is due to capital gains or asset appreciation which Spencer believes has been receiving the greater portion of Productivity Gains.
So, how big is the big bad wolf . . . financial services (not to be confused with bank tellers. Bis 2008 does a nice report on the issue of Financial Regulation here: http://www.bis.org/speeches/sp081119.htm “How Might the Current Financial Crisis . . . ” A few quotes:
– “From 1990 to 2006, the GDP share of the financial sector in the broad sense increased in the United States from 23% to 31%, or by 8 percentage points.”
– “the financial services industry’s share of corporate profits in the United States was around 10% in the early 1980s but peaked at 40% last year (2008).”
What do you believe in portion came from profits? Labor manufacturing a product? A waiter serving dinner? Do you believe there was any Labor involved or was it just bets of appreciation or depreciation and the resulting capital gains? Tax capital gains and quit conflating the issue with the numbers of taxpayers who make a living in payroll wages.
“between 2001 and 2006 the average income of the top tenth of Americans increased about 15 percent a year, to about $250,000, while the average income of the lower 90 percent decreased, the first time since such data was first collected in 1917 that those conditions of increased wealth at the top and decline for everyone else had occurred. More to the point, the average income of the top tenth of wage earners is about 8 times greater than the bottom 90 percent, a wealth gap greater than that under Herbert Hoover during the Great […]
Let me use one word . . . “Baloney.”
Of course you’ve failed to explain why that should make a difference in tax rate, but it is a perfect example of how any distinction can be argued in favor of without any reasonable explanation.
You’re technically correct. Implicit in my statement was that I assumed the goal of taxation was raising revenues to fund the government and further assumed it was self-evident that (1) 20% of something is better than 40% of nothing and (2) attracting/retaining investment capital to our country is a positive good.
I love, “both arguments are reasonable. . . but the only obvious solution is the one I’m proposing”. Is it safe to assume that your advocacy of treating all income the same will also support taxpayers to offset wage income with capital losses beyond the current $3,000 annual limit?
Wow. Talk about conflation.
Okay – well let’s start with that I was discussing pre-tax income. You’re the one conflating pre- and post-tax income. Further, please explain how cuts in the marginal income tax rate lead to differential growth in pre-tax income.
[“the financial services industry’s share of corporate profits in the United States was around 10% in the early 1980s but peaked at 40% last year (2008).”
What do you believe in portion came from profits? Labor manufacturing a product? A waiter serving dinner? Do you believe there was any Labor involved or was it just bets of appreciation or depreciation and the resulting capital gains?]
What do you think all those Goldman bankers are paid from? And if financial profits grew faster than GDP share, doesn’t that imply productivity growth? Are you suggesting that Goldman employees are underpaid relative to their productivity?
And again, we’re talking about pre-tax income, and most Goldman employees are paid income subject to W2. Goldman’s Private Equity arm is a very small component of the overall Goldman, so it has next to nothing to do with the original post.
Once Goldman generates revenues, the dollars can only flow to six places: (1) govt through taxation, (2) shareholders through dividends, share repurchase, or retained earnings, (3) charitable donations, (4) employees through compensation, (5) customers through loan charge-offs, (6) vendors/counterparties/suppliers. The investment banking model has historically targeted a 50% comp ratio. Where are the capital gains of which you speak?
Private Equity is a tiny industry. Blackstone is the largest company and has about $100 bn in assets under management, but only about half of that is for Private Equity type of investments. Blackrock, on the other hand, has about $3 trillion under management. Fidelity, Vanguard, and The Capital Group all have around $1 trillion under management. Franklin Templeton, Legg Mason, Invesco, T. Rowe Price and AllianceBernstein each have roughly $500 bn under management. I’m sure I’ve left some other U.S. asset managers that are around $500 bn or above and there’s a boatload that are between $50 and $500 bn.
Hey, Boy-George Bush did what even Hoover couldn’t do. He skewed income to the upper income tax brackets. They stayed put of gained in income while 95% took a nose dive.
The superstar phenomenon as an explanation for income inequality goes back well before W and was quite prevalent during the Clinton presidency as well.
I think that a lesson that we can learn from the STUNNINGLY MASSIVE CREDIT BUBBLE that we just experienced is that we had more money to invest than our financial system could find decent investments for. Even more of a good thing is not always better. And when you give Wall Street too much money, you end up with a credit bubble, because they can’t figure out anything better to do than lend it to profligate idiots.