Carried Interest: A Very Big Wolf in Sheep's Clothing

Carried interest is not now and it never will be deserving of being taxed as a capital gain, since there is no risk to the money manager and only upside potential.
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In America, we believe strongly in investment as the backbone of economic growth and job creation. This is why I've been strenuously arguing, for several years, for a National Infrastructure Bank that would greatly expand investment in our country's infrastructure and help restore our global competitiveness. Similarly, I believe that a person who invests his money in an enterprise should pay lower taxes on any gains he makes because he is taking on risk and he too is providing capital that makes our economy prosper. We can debate the rate at which capital gains should be taxed -- I think it should be 20% and not 15%, as it is currently -- but the principle behind it is sound.

Yet since the mid 1980s we have -- very unfairly to all other taxpayers -- given this same tax incentive to one, not particularly exceptional group of managers who, rather than managing other people's businesses, manage other people's money in either limited partnerships or limited liability companies. While these money managers are paid salaries, by far most of their compensation is a share of the net gains earned in the entities they manage, which is called "carried interest". The gross inconsistency is that carried interest, by every measure, is no different in substance than the performance or incentive fees which hundreds of thousands of other managers earn every day from the results of the businesses they oversee, whether it be restaurants or department stores or banks, etc.

Yet carried interest is taxed as a capital gain, whereas everyone else's performance or incentive fees are taxed as ordinary income. When these money managers do invest their own money, what they earn on it is of course a capital gain, and it is and should be taxed as such. But carried interest is not now and it never will be deserving of being taxed as a capital gain, since there is no risk to the money manager and only upside potential.

And of course because the 15% capital gains tax rate is less than half the 35% maximum ordinary income tax rate, when this inequity is resolved, the benefit to the U.S. Treasury and all other taxpayers will be on the order of $10-plus billion a year, as I will describe.

To President Obama's great credit, it looks as if Congress, as it considers his recently proposed "American Jobs Act", might finally have the chance to put a stop to this quarter-century-long tax abuse. And while much of the public's attention on this issue has been directed at hedge fund and private equity managers, the management income earned by managers of all investment partnerships needs to be scrutinized: hedge fund, private equity, oil-and-gas, real estate and timber partnerships alike.

However, as the New York Times reported on September 14, "private equity executives and hedge fund managers are [suddenly] apoplectic that President Obama has included [this] provision in his jobs bill." The Times went on to write that, "Private equity and hedge fund firms have exploded over the last decade, and their executives have become among the most powerful and wealthiest players on Wall Street. [Carried interest] ... has become a flash point in the debate over how to pay for programs that will create jobs and stimulate the economy."

We've seen these managers' attack dogs before, and whenever they start attacking, then the treatment of carried interest stays unchanged. But this time, if we can disabuse the three errant arguments likely to come our way, then maybe we can finally get Congressional passage:

  1. First, investment partnership managers will say that this proposed tax reform is nothing more than a vindictive singling out of their firms because of their extraordinary success. They will also say that increasing the tax rate on their earnings to the ordinary income level will create an "investment tax", of sorts, with dire unintended consequences for the entities whose money is being managed and for the American economy. These conclusions are self-serving and complete poppycock. Congress would not be changing the tax rate on investments made by investors -- Congress would only be restoring fairness in how the individuals who manage these investments are individually taxed compared to other managers and other workers. It's beyond disingenuous to predict dire unintended consequences on investing when the consequence would only be to the manager's incentive fee and not even to his base salary.

  • Second, President Obama and the White House have calculated that the amount of revenue to the Treasury from this tax reform would be $18 billion over 10 years, which is even less than the $3 billion per year which two Congressional committees calculated during the last Congress. However, the actual benefit would be on the order of $10 billion per year, which is a massive and critical difference. If the naysayers can persuade Congress in general and especially the twelve members of the upcoming Congressional 'supercommittee' that the revenue to be raised from properly taxing carried interest is only1.8 billion or even3.0 billion per year, then this reform will very likely get swamped by the enormity of the supercommittee's $1.2 trillion 'savings' mandate and be ignored.
  • How do we know the potential benefit is the much higher figure? It's quite simply because of the magnitude of the earnings which are now escaping ordinary income taxation. We know from recent data that there are:

    • More than 1,000 private equity funds managing limited partnership (LP) equity investments aggregating around $1.0 trillion which earn $18 billion or so of carried interest each year;

  • 8,000-9,000 hedge funds managing LP equity investments also of around $1.0 trillion which likewise earn $18 billion or so of carried interest each year; and
  • 1.2 million real estate limited partnerships managing $1.3 trillion of LP equity investments (note: this is not the value of their managed assets) which earn $20 billion or so of carried interest each year.
  • Without even considering the carried interest being earned by the 1.3 million "other" limited partnerships which each year file with the IRS, the sum of the carried interest earned annually by just these three categories of special limited partnerships is more than $50 billion -- and $50 billion times the 20% differential between the ordinary income tax rate (of 35%) and the capital gains rate (of 15%) is $10 billion per year.

  • Third, much of the difference between my calculations and the revenue estimates used by the White House, some in Congress and, especially, the self-serving Private Equity Growth Capital Council is that their revenue estimates "take into account taxpayers' likely behavioral responses in attempting to avoid higher taxes under proposed legislation, as well as the likely success of the proposed legislation at preventing avoidance and collecting those revenues." This methodology -- that tax avoiders will just find other ways to avoid taxes -- has, without any persuasive supporting evidence, been used repeatedly over the years to put off fair-minded Members of Congress from closing tax loopholes. Having been around this space myself for 23 years, I'm not aware of any possible "avoidance schemes" which these managers might possibly take to avoid paying these particular taxes -- and of course the difference between $1.8 billion and $10 billion per year implies an absurd and unrealistic amount of tax avoidance.
  • We must finally slay this big wolf once and for all -- and as it attempts to do so, Congress must not be put off by outright lies, obfuscation and miscalculation. Treasury needs the revenues, the supercommittee needs to meet its obligation with something other than more spending cuts, and the middle class needs to start to see tax fairness restored. Properly taxing carried interest is the perfect place to start.

    There is, however, one part of the President's American Jobs Act proposal which is wrong -- headed, no matter how well intentioned. And that's his proposal -- made over the objections of the Democratic staff of the House Ways and Means Committee -- to tax profits on the sale of an investment management partnership at the ordinary income tax rate. By contrast, right now, proceeds from the sale of every U.S. business, regardless of type, is taxed at the capital gains rate (Peter Lattman, New York Times, 9-14-11).

    The President says that this "enterprise value tax", as he calls it, is needed as a complement to changing the tax rate on carried interest in order to prevent fund managers from circumventing the new rule by selling their businesses to avoid paying higher tax rates on future carried interest income. As much as I want to rein in unfairly taxed carried interest, this 'fillip' is nothing more than a bill of attainder punitively targeting investment management partnerships as the only businesses in America for which proceeds from the sale of the businesses would be taxed at ordinary income rates.

    It is far better, Mr. President, to watch these firms be sold and taxed at the capital gains rate - although I don't think many will be -- than it is it to usurp a guiding principle of the Constitution, which is what your enterprise value tax would do.

    As a final note, just as I was writing this piece yesterday, the President, to his further credit, put forward three additional proposals targeting the highest earners, all greatly overdue and thus all greatly welcome. First, he reiterated his commitment to not further extend the Bush tax cuts for families earning more than $250,000 a year, which was a hallmark promise of his 2008 campaign. While he wavered on this promise in December 2010, when he agreed to their extension for another 24 months, pray God he means it this time and we will see these outrageous cuts finally expire in December 2012.

    Second, he has said he will also limit deductions for families earning more than $250,000. While the proof will be in the details to follow, there indisputably are a myriad number of deductions to pursue which have no national benefit other than further enriching the already extremely wealthy, such as deductions for second homes, yachts, private aircraft use, etc.

    Third, the President proposes levying minimum taxes on the 20,000 to 25,000 individuals earning more than $1 million per year. Except for reforming the treatment of carried interest, no change is more overdue. However, just because Warren Buffett coined the phrase "millionaire's tax" doesn't mean this tax reform should start with individuals earning more than $1 million a year. This is an absurdly high level of annual income, and a figure of, say, $350,000 and not more than $500,000 would be much more appropriate. (Ask the millions of long-time real unemployed workers what figure they think we should start this reform at, and it certainly won't be $1 million!)

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