This is how billionaires enjoy super-low 20% taxes

Marc Lasry
David A. Grogan | CNBC
Marc Lasry

For some, the only thing worse than filing taxes is knowing that others making millions of dollars are paying half the rate.

That's what has long infuriated critics of something called "carried interest," a rule that lets the managers of some private investment funds pay a long-term capital gains rate—usually 20 percent—on the money they make over the year on behalf of their clients. Even though the investment profits are how they're paid—hedge, private equity and venture capital fund managers often don't draw much of a salary—they don't get hit with the top income tax rate of 39.6 percent.

A small but growing group of investment managers thinks that needs to change.

"Taxing carried interest at the same rate as ordinary income is not unreasonable to me," said Marc Lasry, CEO and co-founder of $13.2 billion hedge and private equity fund firm Avenue Capital Group.

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Lasry, who Forbes says is worth an estimated $1.9 billion and co-owns the Milwaukee Bucks, has been a major fundraiser for Hillary Clinton, Barack Obama and other Democrats.

In going public on the subject, Lasry joins a group of prominent current or former investors who believe carried interest should be changed. They include George Soros, Bill Ackman, Tom Steyer, Jim Chanos, Orin Kramer, Steve Rattner and Leo Hindery.

"This is nuts. ... It makes no sense," said Scott Fearon, head of the $100 million hedge fund firm Crown Capital Management. "GPs of both private equity and hedge funds should pay ordinary income tax rates on carried interest because that income is not derived from investing or risking their own money,"

"GP's" refers to general partners, the managers of funds. Their clients are "limited partners."

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The issue remains sensitive for managers. Many of those approached for this report declined to comment or did not respond to requests. A few who said they supported a change also refused to be named, presumably for fear of alienating themselves from peers.

Hedge fund managers are generally more willing to concede that carried interest needs to change because it affects them less. Most hedge funds trade stocks, bonds and other securities within a year, making profits not subject to the lower capital gains rate.

Regardless of what happens, the change wouldn't mean a big dent to the nation's finances. The Congressional Budget Office estimated in 2013 that a change would produce $17 billion in revenues from 2014 through 2023.

The Managed Funds Association, the main U.S.-based hedge fund lobbyist, declined to comment. But the group has previously spoken up against changing carried interest when it was combined with a change to "enterprise value" tax treatment, a break on the sale of a business.

Private equity and venture capital fund managers—who usually hold investments for more than a year—defend carried interest.

"Changing the tax treatment of carried interest would deprive private equity, venture capital, and other partnerships of the same capital gains treatment available to other kinds of businesses that make long-term investments," James Maloney, a spokesman for the Private Equity Growth Capital Council, said in an email. "It would disincentivize entrepreneurial activity required to start, save and grow businesses."

Bobby Franklin, president and CEO of National Venture Capital Association, also stood behind the practice.

"Because future economic growth is strongly correlated to the success of new company creation, discouraging participation in the formation of young startup companies would have a chilling effect on the U.S. economy," Franklin wrote in an email.

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Tricky politics

Politicians—including some Republicans—appear more willing to change carried interest. But Washington watchers say it will likely be tied in with a broader tax reform debate.

"When we do tax reform, I don't see how it's kept out of the conversation—that train has left the station," said Alex Vogel, co-founder of VogelHood Research, a political intelligence firm that works with financial services companies.

While the change has long been recommended by President Barack Obama and Democrats, then-Rep. Dave Camp, R-Mich., included a change to carried interest in a tax plan last year when he was chairman of the Ways and Means Committee.

Indeed, other Republicans may concede the point, but they want to use it as a bargaining tool, according to experts.

"There may be a willingness to give in on carried, but only if they get something for it," Andy Lewin, a principal at lobbying firm Podesta Group.

But tax reform is a rare event in Washington and many think it's unlikely to get done before 2017.

"It's hard to see tax reform getting done before the elections—there are just too many thorny issues," Lewin said.

Rep. Paul Ryan, R-Wis., now runs Ways and Means. He hasn't given a position on carried interest; when asked, a committee spokesman said this: "Our focus is going to be comprehensive tax reform that will help to create a healthier economy."

The spokesman, Doug Andres, added that "some type" of reform remains the goal this year, but that will be determined on finding "common ground" with the Obama administration.

In the Senate, Finance Committee Chairman Orrin Hatch, R-Utah, announced in January that his committee would study taxes in hopes of reform before the election.

A spokesman for the committee declined to comment on Hatch's carried interest views but said the subject would be among those studied by bipartisan working groups.

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Fund managers like Ackman and Dinakar Singh have noted that they are more likely to support a carried interest change if it's part of tax reform.

"I wouldn't object to changing carried interest treatment and [paying] higher taxes if it helps get American back on track," Singh, founder of hedge fund firm TPG-Axon Capital, told Absolute Return + Alpha in 2011. "But it's hard to get behind what's coming out of Washington when it feels like we're being singled out for political reasons and it's not part of more comprehensive tax and fiscal reform that would actually have an impact."