Understanding the "Carried Interest" Issue
Last Friday, Rep. Sander Levin (D-MI) introduced a bill to remedy a long-standing tax inequity that allows private equity fund managers the right to claim performance fee income as capital gains rather than ordinary income. This tax break, based on the misnomer "carried interest," means they pay a 15 percent capital gains tax rate on fees that everyone else pays up to 35 percent in ordinary income tax on. The cost to taxpayers who don't benefit from this break totals $4-6 billion a year.
By industry custom, private equity fund managers' fees are largely, if not entirely based on the investment performance of the funds they manage. This fee structure rewards managers commensurately with the appreciation of the assets under their management. It is a contingency fee, similar to the fee that an attorney earns from a case taken on a contingency basis. Yet no one would suggest that the lawyer's contingency fee income be taxed at the lower capital gains rate.
Why not? Because the lawyer's fee does not arise from the sale of any assets. By the same token, private equity fund managers may not own a penny of the assets under their management. Like lawyers in our example, fund managers run the risk of earning nothing, if the contingency in question does not eventuate. But in neither case do they run the risk of a financial loss, since they are not investors. Without holding and selling fund assets, their income is ordinary income, not capital gains, and should be taxed accordingly.
This anomaly in the law arises from a time when private fund managers customarily did take equity positions in the funds they managed. Such positions were referred to as a "carried interest," – an interest they held as long-term (carried) investors. Profits arising from the sale of this interest were, reasonably, taxed as capital gains. When managers have no equity position in their funds, they cannot be said to have a carried interest – or for their fee-based income to qualify as capital gains.
The issue is no more complex than that. But like so many other business and tax issues, it often gets distorted even by well-intentioned media.
A perfect case in point is the lead editorial in yesterday's New York Times.
The editorial implied a connection between the introduction of the Levin bill last Friday, and Blackstone's noted initial public offering that same day, saying it did not have "its thunder muted" by the bill. The Levin bill has nothing to do with IPOs – in fact, it would explicitly apply equally public and private companies.
The editorial goes on to say that "the tax rules in question were developed decades ago for enterprises that had passive investors to whom gains were passed along. Hedge fund managers and private equity partners are not passive. They're actively managing assets." In fact, to the extent that they are acting only as fund managers and not investors, they are neither active nor passive, as if that distinction, even if it applied, would have tax implications.
Lastly, try making sense of this: "It will also be necessary to narrow the [Levin] bill. For instance, it could include a mechanism to allow compensation to be taken in a form similar to incentive stock options." Nothing in the bill hints at including this mechanism; to do so would expand the scope of the bill, not narrow it.
Although the Times concludes the bill's passage would "achieve a significant victory, for fairness and for fiscal responsibility," it undermines its effort by confusing readers about the bill and the issues involved. The Levin bill deserves serious consideration by Congress and the public, for the reasons the Times indicates. But first, it deserves to be understood… if it is to carry anyone's interest.
How about a 10% flat tax, instead, on either investment income profits, or paycheck, regardless? Income is income, if you pay one dollar in ten, you can learn to bite your lip on the bottom end, and enjoy the benefits on the top end, but nine out of ten ain't bad, and you can adjust your budget, big or small, to match.
And, make the tax liability age start at 18, and end at 65, in recognition of the fact that at both ends of life, you're going to need more money. And, while they're at it, get rid of property tax at age 65. You've done your time,
may as well enjoy the rest of it. Sure, my plan is easy, and it'd put some people out of work, like the 3-card-monte people in the tax refund business, but it's kind of high time for those people to find that elusive Honest Work anyway.
But, my plan has one flaw, if you made the tax system really straightforward, that might expose problems, and that in turn would cause new ones, like recall elections and 60 Minutes going on a 5 year tear, but hey, change is good! LOL
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Good post -- thanks!
Chuck Schumer should be hearing it for taking the wrong side on this important issue.
November 8, 2007 8:20 AM | Reply | Permalink
I hope I can ask a couple of questions here...
Dana,
First off, thanks for a great column. I've given out the link many times. You do a super job of explaining the issue.
Has anything been done, or is this still the tax rate on the "carried interest" for private equity fund managers?
Do you know how long the tax code has been like this, allowing these managers to pay at the cap gains rate?
Thanks,
Wally
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