Taxes on Carried Interests

[PaloAltoCougar]

Romney is being blasted on this, and it'll get worse if he's the nominee, despite having done nothing wrong under existing tax law. But should the tax law be changed? I couldn't find a CUF discussion on this, andt I apologize if this has already been flogged to death. But today's NYT article about Bloomberg and how he, Buffet, Obama and others would like to see carried interests taxed at ordinary rates has me thinking about this again.

As I understand it, a "carried interest" is a fund manager's share of the fund's profits. Those profits consist mainly of long- and short-term capital gains upon the sale of the various stocks the fund owns. Investors in the fund receive capital gains treatment because they invested money in the fund, and thus the gains are simply a return on their investment, as if they had purchased the underlying stocks themselves (and btw, I'm fine with capital gains tax treatment on money that an investor puts at risk). But the fund manager didn't invest his own money to receive his carried interest, and didn't have any money at risk. Rather, his carried interest is his reward for wisely managing the fund and producing profits for the investors.

Typically, compensation for those efforts would treated as ordinary income, not capital gains, and thus would be taxed at a much higher rate. But for whatever reason, carried interests are also given capital gains treatment. I can't understand why wealthy fund managers get to have their compensation taxed at capital gains rates, while other service providers (e.g., teachers, lawyers, accountants, janitors, etc.) are taxed at ordinary rates.

It'd be great if all taxes could be reduced, but within the current tax system, I'd like to hear a good argument why carried interests are entitled to beneficial tax treatment. Viking? Others?

[doctorcoug]

Reaganomics?

[byu71]

imho carried interest should be taxed as ordinary income. i would like to see what senators and reps have voted to give this break. i will bet Chuck Shumer voted in favor.

[Viking]

Romney is being blasted on this, and it'll get worse if he's the nominee, despite having done nothing wrong under existing tax law. But should the tax law be changed? I couldn't find a CUF discussion on this, andt I apologize if this has already been flogged to death. But today's NYT article about Bloomberg and how he, Buffet, Obama and others would like to see carried interests taxed at ordinary rates has me thinking about this again.

As I understand it, a "carried interest" is a fund manager's share of the fund's profits. Those profits consist mainly of long- and short-term capital gains upon the sale of the various stocks the fund owns. Investors in the fund receive capital gains treatment because they invested money in the fund, and thus the gains are simply a return on their investment, as if they had purchased the underlying stocks themselves (and btw, I'm fine with capital gains tax treatment on money that an investor puts at risk). But the fund manager didn't invest his own money to receive his carried interest, and didn't have any money at risk. Rather, his carried interest is his reward for wisely managing the fund and producing profits for the investors.

Typically, compensation for those efforts would treated as ordinary income, not capital gains, and thus would be taxed at a much higher rate. But for whatever reason, carried interests are also given capital gains treatment. I can't understand why wealthy fund managers get to have their compensation taxed at capital gains rates, while other service providers (e.g., teachers, lawyers, accountants, janitors, etc.) are taxed at ordinary rates.

It'd be great if all taxes could be reduced, but within the current tax system, I'd like to hear a good argument why carried interests are entitled to beneficial tax treatment. Viking? Others?

Should we tax gains on founder's stock at ordinary rates?

Should Steve Jobs's family/foundation be taxed at ordinary rates for stock options he received for performance milestones achieved while at Apple?

[Pelado]

In this video, Paul Levy of JLL Partners Inc (a private equity firm) indicates that the managers of private equity funds generally invest a lot of their own cash into the fund.

http://www.bloomberg.com/video/84449900/

Even so, it seems that it shouldn't be too difficult to bifurcate the return on capital from the firm's profits on its deals. I don't see a very compelling argument for full capital gains treatment.

[Moliere]

Interesting question (of course I'd think it's interesting) and something I know nothing about as I've never heard of "carried interest". Just based on some findings on wikipedia I noted this:

n private equity, in order to receive carried interest, the manager must first return all capital contributed by the investors, and, in certain cases, the fund must also return a previously agreed-upon rate of return (the "hurdle rate") to investors

If this is true then it doesn't sound like ordinary income at all. We aren't talking about pay the manager gets no matter what but instead he only gets paid after the equity investors get back their investment plus return. So basically the manager is lower than the equity holder in terms of getting getting anything.

Obviously whether or not the manager actually puts in money to the fund can change the character of the income received through carried interests, but I'm not sure even without his own investment that I'd classify it as ordinary income.

I guess what I'm saying is that I see the argument to tax it as OI but I think the argument (based only on wikipedia details) for capital gains is stronger.

[Moliere]

Typically, compensation for those efforts would treated as ordinary income, not capital gains, and thus would be taxed at a much higher rate. But for whatever reason, carried interests are also given capital gains treatment. I can't understand why wealthy fund managers get to have their compensation taxed at capital gains rates, while other service providers (e.g., teachers, lawyers, accountants, janitors, etc.) are taxed at ordinary rates.

I might also be wrong here as well, but isn't there really two different incomes for the general partner......carried interests and management fees? So the management fees are taxes at OI rates since they represent payment for services provided and the carried interests are taxes at CG rates. Doesn't seem illogical as long as the management fees are reasonable for the services provided.

[PaloAltoCougar]

Should we tax gains on founder's stock at ordinary rates?

No, because they are actually equity owners, and became such by contributing cash, IP and other assets. A fund manager's carried interest wasn't obtained because of a capital contribution.

Should Steve Jobs's family/foundation be taxed at ordinary rates for stock options he received for performance milestones achieved while at Apple?

Yes, and they probably are. The options you describe would likely be nonqualified stock options because incentive stock options are not transferable, and NQSOs are always taxed upon exercise at ordinary rates. Even if they are incentive stock options, they'd be subject to the alternative minimum tax, effectively negating capital gains treatment.

[PaloAltoCougar]

I might also be wrong here as well, but isn't there really two different incomes for the general partner......carried interests and management fees? So the management fees are taxes at OI rates since they represent payment for services provided and the carried interests are taxes at CG rates. Doesn't seem illogical as long as the management fees are reasonable for the services provided.

But I still don't get why the carried interest should be entitled to preferential tax treatment. If a CEO does a really outstanding job of managing a company, and he's given a huge (and much deserved) bonus, should the amount above his reasonable salary be taxed at capital gains rates? Or how about the contingent fee lawyer (which I am not)? If he wins a huge award for his client, and takes his 30-40% fee, should he be taxed at ordinary rates on what his hourly rate would have been, and at capital gains rate on the huge excess?

In both cases, they'd be taxed at ordinary rates on every thing they earned.
I think the carried interest of a successful fund manager should be as well, in the absence of a compelling argument otherwise, which I haven't heard yet.

[Viking]

No, because they are actually equity owners, and became such by contributing cash, IP and other assets. A fund manager's carried interest wasn't obtained because of a capital contribution.



Yes, and they probably are. The options you describe would likely be nonqualified stock options because incentive stock options are not transferable, and NQSOs are always taxed upon exercise at ordinary rates. Even if they are incentive stock options, they'd be subject to the alternative minimum tax, effectively negating capital gains treatment.

Would you consider intellectual capital a form of IP? An other asset?
What about process? Is that IP? Also an other asset?

[Moliere]

But I still don't get why the carried interest should be entitled to preferential tax treatment. If a CEO does a really outstanding job of managing a company, and he's given a huge (and much deserved) bonus, should the amount above his reasonable salary be taxed at capital gains rates? Or how about the contingent fee lawyer (which I am not)? If he wins a huge award for his client, and takes his 30-40% fee, should he be taxed at ordinary rates on what his hourly rate would have been, and at capital gains rate on the huge excess?

In both cases, they'd be taxed at ordinary rates on every thing they earned.
I think the carried interest of a successful fund manager should be as well, in the absence of a compelling argument otherwise, which I haven't heard yet.

I'm not really trying to make a compelling argument, just trying to understand the issue and throw out some reasons as to why it's treated this way. Well, we all know the real reason why (because PE firms and hedge funds have lots of political capital).

So, separating the management fee from the carried interest and given that management fees are taxes as OI and they pretty much represent a "salary" per se, that leaves us to characterize the type of money that constitutes carried interests. Assuming that this is a partnership and that it has invested in long-term investments, why should the partner that gets the carried interests not get the same tax treatment on his income that the other partners get? He's already received his management fee and that has been taxed at OI. I guess what I"m saying is that an argument could be made that, after all expenses are paid out of the partnership (including the management fee) the remaining income is passed-through to the partners based on the character with which it was earned. Meaning that if the income is a capital gain to the partnership it is flowed-through as a capital gain to the partners. Why should one partner's allocation of income result in the taxable character of that income being changed while all the other partners get the flow-through benefits of the partnership?

[PaloAltoCougar]

Would you consider intellectual capital a form of IP? An other asset?
What about process? Is that IP? Also an other asset?

Yes to any of the above, if it's proprietary to the contributor, and is identifiable (can be reduced to a writing) and tradeable. If it's just the general smarts of the contributor, then no.

[Topper]

http://www.csmonitor.com/Business/Ro...s-tax-loophole

It seems unjust.

[byu71]

Would you consider intellectual capital a form of IP? An other asset?
What about process? Is that IP? Also an other asset?

Intellectual capital?? Maybe I don't understand what that is. Do royalties on books get treated as OI or capital gains?

[PaloAltoCougar]

I'm not really trying to make a compelling argument, just trying to understand the issue and throw out some reasons as to why it's treated this way. Well, we all know the real reason why (because PE firms and hedge funds have lots of political capital).

So, separating the management fee from the carried interest and given that management fees are taxes as OI and they pretty much represent a "salary" per se, that leaves us to characterize the type of money that constitutes carried interests. Assuming that this is a partnership and that it has invested in long-term investments, why should the partner that gets the carried interests not get the same tax treatment on his income that the other partners get? He's already received his management fee and that has been taxed at OI. I guess what I"m saying is that an argument could be made that, after all expenses are paid out of the partnership (including the management fee) the remaining income is passed-through to the partners based on the character with which it was earned. Meaning that if the income is a capital gain to the partnership it is flowed-through as a capital gain to the partners. Why should one partner's allocation of income result in the taxable character of that income being changed while all the other partners get the flow-through benefits of the partnership?

I appreciate the effort, and I've devoted a lifetime to helping others achieve capital gain treatment whenever possible, but I'm still not seeing it. Using the argument you provided, shouldn't that apply to corporations as well? The corporation's officers' job is to maximize the wealth of its shareholders. If
they succeed, their shareholders receive capital gains and dividends that receive preferential tax treatment. Assuming the returns are huge, and the board of directors believes the officers are entitled to megabonuses beyond the very hefty salaries the officers received, should those bonuses also be given preferential tax treatment, since their source was the capital gains their efforts produced?

I'm still of a mind that a return on contributed capital should be given preferential treatment, but any return that results from one's efforts, no matter how valuable, should be treated as compensation (i.e., ordinary) by the recipient, even if the recipient regards his/her brilliance as capital.