Close The Carried Interest Tax Loophole Now

Money bag
Money bag

The New York Times has recently published two opinion pieces, which argue opposite sides of the issue of the carried interest tax loophole. The first, Close My Tax Loophole, is by Alan Patricof, a co-founder and managing director of Greycroft, a venture capital firm. The second, The Carried Interest Loophole? What Loophole?, is by Steven Klinsky, the founder and CEO of New Mountain Capital, a private equity firm. (Full disclosure: I am acquainted with, like and respect both Patricof and Klinsky.)

I've been very vocal about this issue for many years, calling on the government to immediately close this absurd and unfair tax loophole, but not for the reasons you might think: I don't really care that it solely benefits not the one-percenters, but the one-basis-pointers; that, as Patricof writes, it reinforces "a toxic belief that the country's economic order is rigged against ordinary Americans" and "feeds the cynicism that is fraying our democracy"; nor am I calling on anyone to pay more taxes out of a sense of patriotism.

Rather, to me it's just common sense: the carried interest income earned by managers of private partnerships (like Patricof, Klinsky and me) is no different from the year-end bonus a shoe salesman at Nordstrom might receive -- and both should be taxed as ordinary income.

Klinsky argues that it's not the same. He writes:

Let's say a father and a son go into business together to buy the local lawn mowing company for $1,000. The father puts up the money and the son does all the work of having the idea, managing the partnership and so on. They agree to split the partnership's future profit 80 percent for the father (as the passive, money limited partner) and 20 percent for the son (as the active, hands-on general partner). If years later, the partnership is sold for a profit, there would be long-term capital gain on that profit. The father would own 80 percent of the profit and pay 80 percent of the capital gains taxes. The son would own 20 percent of the profit and pay 20 percent of the capital gains taxes.

Private equity works the same way, under the same tax rules, with no special rule or loophole.

It's a clever argument, but Klinsky is making the wrong analogy when he compares the hypothetical lawn mowing company to the companies he invests in rather than his own business, New Mountain Capital.

The key question to determine whether income should be taxed as ordinary income vs. capital gains is whether money is being invested and is at risk. Clearly, this is the case with both the lawn mowing business as well as the business Klinsky founded and built, New Mountain Capital - if either of these businesses were sold, no-one would dispute that the gains would correctly be taxed at the favorable capital gains rate.

But Klinsky is taking the argument much further -- in a way that defies logic and common sense in my opinion. He's in the investment management business: investors (limited partners or LPs) give his firm (the general partner or GP) billions of dollars, which it invests in a range of companies, helps them become more valuable, and then hopefully sells them at a profit. (It's the same thing I do with my hedge fund, except I'm investing in public companies via their stocks rather than negotiated investments in private companies.)

As with most private investment partnerships, 80% of the profit goes back to the investors and 20% (the carried interest) is kept by New Mountain Capital for a job well done (note that this is above and beyond the annual management fee investors pay).

Klinsky claims that the carried interest his firm earns, when passed through to its owners like him, should be taxed as capital gains, just like the 80% of the profits earned by the LPs. I disagree because, unlike the LPs, the GP had no money at risk (other than what is usually a small amount the GP invests alongside the LPs, which is also taxed favorably). To be sure, the carried interest is variable (and can, of course, be zero), but it's not an at-risk investment; rather, it's a bonus: if the partnership makes money, the GP keeps 20% of the upside, but if it loses money, the LPs suffer 100% of the losses while the GP loses nothing.

It is this simple equation that makes money management the best business in the world in my opinion. But does it make any sense that the taxman should put an extra cherry on top of this already-delicious sundae by allowing a few thousand of the very wealthiest people in the world to pay a far lower tax rate on their bonus income than anyone else?

Obviously not.

This absurd and unfair tax loophole should be closed immediately.

Appendix A: Q&A
Whenever I engage on this issue, I consistently hear a number of arguments, so allow me to address them here.

1) You're just engaging in class warfare. No I'm not. I'm fortunate enough to be part of the 1% and run a hedge fund, so I benefit from this loophole. Rest assured I'm not engaging in warfare against myself, my family and my friends. This is just about basic fairness and common sense.

2) People who benefit from this loophole already pay a lot of taxes. That would be true even if they paid a 1% tax rate.

3) But they also pay a high tax rate. Some do, some don't. I don't care. This is just about basic fairness and common sense.

4) But if you raise the tax rate of investors and business builders like Klinsky and Patricof, they'll invest less, might not work as hard, might retire earlier, etc. If you believe this, please contact me, as I have a bridge in Brooklyn to sell you.

5) You're attacking the patriotism of those who disagree with you on this issue. Some folks have raised this issue. I have not. This is just about basic fairness and common sense.

6) New Mountain Capital is an excellent, highly successful business that has helped businesses grow and create jobs. Agreed. And if Klinsky ever decides to sell it, his gains will rightly be taxed at the favorable capital gains rate. But the bonus carried interest income his firm earns every year should obviously be taxed as ordinary income.

7) Taxing carried interest as ordinary income wouldn't generate much money relative to the estate tax, the overall budget, or any other relevant metric. Hey, a billion here, a billion there, a soon you're talking real money! Also, if it's so de minimis, then why is there such a huge fight to maintain this favorable tax treatment?

8) If you think carried interest should be taxed as ordinary income, then why don't you calculate what it would be for yourself and just voluntarily pay this higher amount (and shut up about it for the rest of us). This argument is so ridiculous that I'm not going to dignify it with a response.

Appendix B: Response from Klinsky

I shared this article with Steve Klinsky prior to publication and he asked me to include his response:

I appreciate you rerunning my piece and the sincerity of your good intentions. That said, I think you and Alan Patricof are simply misstating the way the tax law actually works, inside and outside of private equity for the last 100 years, and are simply failing to recognize the category commonly known as "sweat equity".

I gave the example of the lawn mower company because it is easily understood that the son would get capital gain treatment on his ownership piece, even though the son put up no money for that piece (and put up many millions of dollars less than private equity investors typically invest personally in their companies). Similarly, in the corporate context, many businesses begin on a financial shoe string, with little initial investment at risk. Think of every college kid in a dorm room, or the local sign painter who incorporates himself as "Painter, Inc.", or the guy who has no money of his own but takes out a loan to buy the little business he has worked in from his retiring boss.

If the sweat equity was in fact a bonus, someone would be able to take an ordinary tax deduction for paying the bonus. No one does take a bonus deduction, because sweat equity is NOT a bonus. It is co-ownership, received at a time before the ownership piece had any clear value. If the dad in my lawn mower example got an ordinary income bonus deduction and the son got an ordinary income bonus tax, the two would offset and the capital gains tax for the government would be essentially unchanged.

By failing to even mention sweat equity (or partnership service interests as they are more technically called) you and Alan Patricof simply assume away 100 years of precedent without even mentioning it. If your "significant money must be at risk" concept applies to private equity owners, it would apply by the same logic to raise taxes on every other type of entrepreneur who uses limited or no money to start or buy a piece of his business. Your policy would end up being a drastic change in the law and a direct attack on many forms of entrepreneurship.