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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.


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.