Why Carried Interest Shouldn’t Be Taxed as Capital Gains

Yes, the cruelest month has begun, marked at its dead center by tax day. We have a Freakonomics Radio segment tonight on Marketplace about some tax-collecting ideas. Here, from John Steele Gordon in today’s Wall Street Journal, is a compelling attack on the practice of treating carried interest as capital gains. Would love to hear in the comments from some private-equity and hedge-fund folks why/how Steele isn’t right:

To defend the favored treatment of carried interest, private-equity and hedge-fund owners argue that their share of the customers’ gains is analogous to “founders stock,” which is granted to the founders of a company when it goes public, even though they may not have personally invested money in the venture.

This analogy is bogus when the companies in which a fund is invested are not actively managed. A founder has a bright idea. He works hard to convince others of its worth so that they will invest in it. He works hard to get the company off the ground, investing his time and his sweat equity in the business (not to mention the forgone income from the 9-to-5 job he could have had instead). He is risking a lot: a substantial portion of his working life, his reputation, his potential current income, etc.

What does a hedge-fund manager risk? His is an on-going business, not a start-up. His business is, in effect, giving investment advice to clients. If his advice nets to a profit he is rewarded with a portion of the gain. How does that differ from, say, a lawyer taking a case on a contingency basis and sharing in the award when the case is successfully settled or won? The lawyer is giving legal advice and being compensated for giving good advice. But that compensation is taxed as ordinary income.

And:

Unlike Warren Buffett‘s phony self-example — where he ignored the corporate income tax paid by Berkshire Hathaway and thus claimed to pay a lower tax rate than his secretary — carried interest is a genuine case of the staff paying higher income-tax rates than the boss. And it is flat-out wrong. 

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  1. Jason DaCruz says:

    Interesting take on lawyer-pay. I guess one could make that analogy for any sort of commission-based job.

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  2. Raj says:

    Under the same assumptions, shoudn’t one be taxed at standard federal rates when investing in the stock market?

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    • YouTony says:

      The difference is that hedge fund managers are allowed to pay the lower tax rate for profits derived from investing (mostly) *other people’s money*, not their own, as you do when you buy stock for yourself and pay the lower capital gains tax.

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  3. Jason says:

    I work at a hedge fund, and I agree, it is time for carried interest to be treated as normal income. It seems the politics of the current environment seem to be moving more and more towards taxing capital and labor equally.

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  4. Political Punnery says:

    “Unlike Warren Buffett‘s phony self-example…”

    What’s phony about it? According to the Supreme Court, Mr. Berkshire Hathaway is a completely separate and totally existent person. His tax bill is his own, not Warren Buffet’s.

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    • Matt says:

      Because Buffett is ignoring the corporate income tax that’s taking a substantial share of the profits he’s being taxed on. Since he’s getting a more-or-less fixed percentage of Berkshire’s profits, that amounts to a shell game: he’d be making a lot less, giving a lot more to the government, and be taxed at a much lower rate than his secretary if the corporate tax rate were 75% and his capital gains tax rates were 0. As it is now, for every $100 in profit Buffett’s share of Berkshire makes, he’s effectively making $50 between the two taxes.

      If you’d prefer to insist that his personal tax rate is all that matters, then let’s set the corporate tax rate to 0 and tax his capital interest as regular income. He’d personally be paying a lot more, and unless he lives in California would probably come out ahead.

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      • Political Punnery says:

        I think you’ve missed my point.

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      • Aaron says:

        But his secretary is also paid by the corp who pays taxes. If the corp wasn’t paying taxes, she would get a better salary. She is also double taxed, just as Warren is.

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      • Oscar says:

        Actually the secretary is paid BEFORE paying corporate taxes. Actually she gets paid even before paying any interests to a bank.

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      • Aaron says:

        Oscar,

        You are missing the point. Yes, the secretary is a deductible expense, and paid prior to corp tax, but the corp is still taxed on earned income like a regular entity. If they weren’t, she would receive more money. Suppose the corp was taxed at a lower rate? Well than, that wealth may have been transferred to her.

        Second, It is true that dividend and stock appreciation will be taxed again when realized, but there are other provisions that offset this appreciation. When WB passes on, none of that appreciation is taxed. (§1014). Third, he can – and probably does – “borrow” on said securities until he in fact does die. Thereby really only paying once, just as his secretary.

        So yes the corp pays taxes, but WB has the option of shifting the tax burden to a later date (capturing the increase value) or none at all, something the secretary cannot do.

        One must look at the tax code as a whole. Believe me, WB pays less effective tax than his secretary. Whether that policy is good or bad is another story.

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      • EP says:

        Aaron: Why would she get a higher salary? Those additional non-taxed profits belong to the shareholders, e.g. Mr. Buffet, to do with as they please. Being an investment company as they are, I have an educated guess as to what they would do with the money.
        Moreover, I rather doubt there’s any impediment to increase the good secretary’s salary (N.B. she already owns two houses, and otherwise does quite well for herself: http://www.forbes.com/sites/paulroderickgregory/2012/01/25/warren-buffetts-secretary-likely-makes-between-200000-and-500000year/)

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      • pawnman says:

        I’ve always thought the corporate tax rate should be zero. One of the first things we learned in undergraduate business is that corporations don’t pay their own tax bills. The consumers pay it with higher prices, the employees pay it with lower wages and benefits, the suppliers pay it in lower negotiated prices for their goods/services, and the shareholders pay it in the form of decreased profits.

        End corporate taxation and you’ll not only see a more productive economy, you’ll see a lot less of the giant corporate lobbyists in Washington trying to change the tax laws. I’d also like to see and end to corporate subsidies. If your business can’t succeed on its own, it’s time to find a new line of business.

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    • James says:

      What is really phony about the Buffett example is that it fails to mention that (unless Buffett pays his secretary extraordinarily well), the secretary is paying a lower rate on his/her capital gains than Buffett is, and is also paying a lower rate on earned income.

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  5. Seminymous Coward says:

    The problem is classing any form of income as special, whether it’s wages, capital gains, or commissions in one particular industry.

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  6. WiseFather says:

    But the hedge-fund managers bought that tax break legally through campaign contributions, and their children will starve and/or freeze to death without it! Please won’t anyone think of the hedge-fund children!

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  7. Johnny (@MoneyWonk) says:

    I’m in the industry, and I agree that it should be taxed as ordinary income. What Mitt Romney and Ed Conard advocated last year on the campaign trail – that carried interest should be taxed at a lower rate to compensate them for the risk incurred – is completely false. They may invest a small amount of their own money, but the majority of their compensation comes in the 20% “carry” they take off the top of their investors’ profits. So who is taking the risk and who should be given the favorable tax treatment for participating in the “creative destruction” of the private equity industry? The answer is the large pension funds and endowments that invest in private equity.

    …it begs the question: where are all the customer’s yachts?

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  8. John S says:

    Hidden due to low comment rating. Click here to see.

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    • Matthew says:

      IMHO, you do this discussion a disservice couching the arguments as you do. If a PE manager invests his own funds then he is entitled to capital gains treatment of any gains on his own investment. Carried interest, on the other hand, is a transfer of assets from one entity (the investor) to the PE manager. From the manager’s point of view, he has something he did not have before. Consequently, it is income, rather than gain.

      The fact that changing the classification of carried interest will fund the government for 5 minutes or five years is irrelevant; the issue is fixing something to make it right. In addition, the impact on asset owners invested in PE is likewise irrelevant. Previous returns were artificially inflated because of an incorrect policy, future returns only reflect what should have been in the first place.

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    • Johnny (@MoneyWonk) says:

      I agree that fund managers put their money and time at risk, and should be compensated appropriately. However, this only justifies a low tax rate on the money they actually invested. A fund manager may have 1% or (significantly) less of their own money invested in the fund, but receive up to 20% of the profits. If you wanted to be fair, then the return on invested funds should be taxed at the capital gains rate, as this is the only share of the fund manager’s money that has actually been put at risk. All other compensation received, well, that’s income, and should be taxed accordingly.

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