The practice of hedge fund managers being compensated through a carried interest in investment partnerships has received a lot of attention from some in Congress and President Obama. Multiple bills have been submitted to change the tax character of carried interests for hedge fund managers to ordinary income. These include the Carried Interest Fairness Act of 2012, introduced by House Ways and Means Committee Ranking Member Sander Levin (D-MI).
The primary reason mentioned for the change is based on the claim that compensation to a hedge fund manager shouldn’t be taxed any differently from income earned from other occupations.
To properly analyze the carried interest issue, we need to focus on two important tax concepts. One is the ability for a partner to provide services to a partnership in exchange for a carried interest. The other is the differential between the tax rates on ordinary income and long-term capital gains. These two concepts often have been conflated in discussions related to this issue and need to be examined separately to bring clarity.
A carried interest – or, as it is referred to in the tax code, a profits interest -- is a business arrangement where a partner receives an allocation of partnership income, retaining the underlying tax character, in exchange for providing services to the partnership. The underlying tax character can be capital gains, which are long-term or short-term depending on holding period, or ordinary income. The current top rates for each are 15 percent, 35 percent and 35 percent, respectively. The partner receiving the carried interest is not required to contribute capital for this share of the profits.
Carried Interests for Others
Granting a profits interest is not a special carve-out for hedge fund managers but is instead a well-established provision of the tax code. The attractiveness of a profits interest is that it brings together those who have the ideas and are willing to manage the business with outside investors who will supply the capital. Carried interests are even used in some accounting and law firms as a tool to retain talented employees. Although many businesses avail themselves of carried interest structures, it is primarily the hedge fund community that is being targeted with the proposed legislation.
Legislators claim the services performed by hedge fund managers are indistinguishable from those performed by teachers or others who have their income taxed at ordinary rates. They may or may not have a point. However, under current tax law, the profits interest arrangement is allowable. If access to this provision is blocked for hedge fund managers, then it begs the question, why would others such as lawyers who receive carried interests be allowed to continue using a carried interest structure?
Capital Gains vs. Ordinary Income
It appears those who want to eliminate carried interests for hedge fund managers do not have an issue with the concept of carried interests in general. If they did, they would want to ban it in totality. With the only distinguishing factor related to hedge fund managers being that they can generate long-term capital gains, it appears the substantive issue is the larger debate over the gap between the tax rates for ordinary income and long-term capital gains.
Capital gains are taxed at lower rates for various reasons, including encouraging people to take risks, and recognition that people use after-tax money to make investments. The lower capital gains rate helps soften the impact of double taxation of invested funds.
If legislators disagree with the gap in rates, then it would be more productive to debate whether long-term capital gains should be taxed at a different rate as opposed to introducing legislation that targets an industry’s allocation of their legitimate taxable income.
The legislation bans the manager from receiving compensation in any form besides ordinary income and forces the partnership to allocate individual taxable items, including long-term capital gains, amongst the other investors. Because there is no reduction in income taxed at 15 percent, as it is only reallocated, and given that the tax effect from the ordinary fee income claimed by the manager will come close to being offset by the tax write-off by the investors, the net effect of the proposed legislation would be minimal. This is evident as the average annual tax revenue is estimated to be $1.3 billion or 0.03 percent of the proposed 2013 federal budget, not even a rounding error.
‘Significant Complexities Added’
Implementation of the legislation would be burdensome to the many businesses that would be affected, including real estate ventures and possibly proprietary trading firms. The American Bar Association’s Section of Taxation has stated, “. . . we believe Proposed Section 710 [addressing carried interests] would add significant and burdensome complexities to the Code and alter fundamental principles of partnership taxation.”
To give an idea of the added complexity, the proposed new code section is 3,060 words long. This compares to an 88-word count for another critical and important existing code section relating to partnership taxation.
In addition, some of the proposals do not contain what are referred to as “grandfather clauses” that allow existing agreements to stay unchanged. The effect of this is that every agreement that is currently in place would need to be renegotiated and rewritten. That would be a massively expensive and time-consuming undertaking.
It’s clear the proposed legislation regarding carried interests is a misguided and burdensome exercise that would produce little or no benefit to the government while unnecessarily adding to the complexity and expense of running a business.
Jeff McKinley (email@example.com ) is a certified public accountant and president of Senex Solutions LLC.