Private equity and real estate managers get a "costly and unjust [tax] perk"
by Linda Beale
Private equity and real estate managers get a “costly and unjust [tax] perk”
Through a process of Wall Street interpretation of the law and the “Wall Street Rule” (that says that the government tax administration will have great difficulty gainsaying an interpretation of the tax laws that lots of high-powered–read “wealthy”–Wall Street bankers and friends have arrived at for their own benefit), private equity fund and real estate investment partnerships have long operated under the assumption that their managers can earn compensation income as though they were “partners” in the firms they are managing, even though they make no capital contribution whatsoever. This is the so-called “carried interest” treatment of so-called “service partners” who receive a so-called “profits interest” in various types of investment partnerships for managing the assets.
Various commentators, myself included, have long argued that carried interest should be taxed as ordinary compensation income, just like everybody else’s compensation for work done. I would go further. The Internal Revenue Code provides for capital interests that are received, in a nonrecognition transfer, for contributions of capital to the partnership. According to The Property Buying Company, the concept of profits interests is developed in regulations and lower-court case law, both of which could be overturned (as in General Utilities “repeal” when a court case allowing distribution of appreciated property from corporations without tax to the distributing corporation was “repealed” through a statutory enactment of a provision that required gain recognition) by a legislative restructuring of the partnership provisions to make clear that there is no such thing as a service partner other than one who has made a contribution of equity and who also works for the partnership and receives a “guaranteed income” payment of compensation.
There are many in Congress who recognize the unfairness of the carried interest compensation loophole–not only does an interest that is claimed to represent a portion of the partnership’s capital gain income get taxed at a much lower preferential rate than ordinary compensation, but it also avoids all the payroll taxes that the lowliest wageearners must pay. Sannder Levin, a Michigan Democrat, introduced a bill in 2007 in Congress that would have taxed carried interest at ordinary rates. It was defeated by massive lobbying by the private equity, hedge fund, and real estate millionaires (and billionaires).
As Lynn Forester de Rothschild notes in her op-ed in today’s New York Times, A Costly and Unjust Perk for Financiers, New York Times (Feb. 25, 2013):
This state of affaires denies our Treasury much-needed revenue; fuels public cynicism in government; and is evidence of the ‘crony capitalism’ that favors some economic sectors over others.
It is time for Congress to end this travesty. Tax compensation to private equity fund mangers and their ilk as what it is–compensation income for services rendered to investors.
cross posted with ataxingmatter
There’s a problem with this idea of abolishing carried interest.
And that’s that the proposed “solutions” would also mean taxing sweat equity as income not capital gains.
So, imagine you’re starting a new company (as I have just done but not under US tax laws). You take in some amount of equity investment (as I have just done) and there is some amount of that equity that goes to the founder (as has just happened to me).
Now, that founder’s equity doesn’t come to me because I’ve put money into the company. It’s coming to me because I’m managing it. Running it.
So, I am getting that equity in return for my labour, yes. And you can certainly argue that therefore I should be paying income, not capital gains, taxes on it.
But that’s most certainly not the way most tax systems (including the US one) treat such founder’s equity.
It’s taxed, assuming that the company succeeeds of course, at capital gains tax rates.
This is indeed directly equivalent to that carried interest stuff. Indeed, carried interest is in fact those fund managers making exactly this argument: that it is akin to founder’s equity and thus should pay capital gains tax.
Which leads to the problem over these proposed solutions to carried interest. If you’re going to say that only those who actually invest money for equity, rather then labour, time or expertise, then how do you make sure that it’s only those fund managers who get caught, and not founders of companies?
I’ve not yet seen anyone manage to construct a scheme that manages to distinguish between these two scenarios.
Anyone care to try?
It’s easy to distinguish the two. All that has to be done is legislatively declare that carried interest income (i.e., income based on contractual work, as opposed to capital) is ordinary income. It won’t apply to you. Presumably, you and your investors have already decided what amount (if any) you will be paid for your work in the form of salary. You pay ordinary income tax rates on that salary. If your company goes up in value, and you sell, it’s all capital gain to you. (tax nuances aside, depending on the legal structure)
“Carried interest” is NOT sweat equity. It’s compensation for work performed, essentially paid to non-owners.