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The Biggest Mistake in the Hedge Fund Tax Debate

AP

The debate over how to tax the profits interests of hedge funds is carried out on a deceptively simplistic level that misleads lots of people.

The basic facts are straightforward enough. Most hedge fund managers receive two types of compensation. The first is a fee on the assets under management, often 2 percent of the fund.

The second is a share of the profits, often 20 percent of the profits beyond some hurdle levels (such as the return of all initial outside investment or surpassing the performance of the S&P 500).

The first form of compensation is usually taxed as ordinary income—where the highest marginal tax rate is currently 35 percent.

The second form—called “carried interest” or “the carry” in the jargon—is often treated as a capital gain under current law.

It’s that second type that sticks in the craw of the tax hikers. To them it is obvious that this kind of compensation is not a capital gain. They insist it is rather obviously a fee for the service of running the hedge fund. From here they jump to the conclusion that it should be taxed as ordinary income.

But this is way too quick. Things aren’t really as simple as all that.

In fact, the argument that “carried interest” deserves to be treated as ordinary income rests on a core assumption that is just plain false.

“Capital gains are gains on capital invested. These are fees. That's income,” James Mackintosh, the investment editor at the Financial Times,

.

But not all capital gains are gains on capital invested.

Let’s say you buy a piece of undeveloped property in the Catskills in upstate New York. Your initial purchase price is the capital you invest. If the price goes up over time because the market for Catskills mountain property improves, you’ve clearly made a capital gain. If, say, someone discovers your property is on top of an easily developed shale deposit, then you’ve made a capital gain.

But let’s say, instead, you spend a few years gathering falling trees and building a house on the property. Let’s say the existence of the house improves the price you can ask for the land. Now it was your years of labor—your service of home building—that improved the value.

There’s no other source of price appreciation.

When you sell the house, is this income for services? Or is it a capital gain? Under the law, it’s most likely a capital gain.

Or let’s say you launch an Internet start-up. You develop a killer iPhone app. You attract some outside investors to whom you sell a portion of the company in exchange for cash to build out the app. You collect a salary for a couple of years—which is taxed as ordinary income. Then you sell the company to Google.

The main thing that increased the value of your company was your labor and the capital of your investors. So do your investors get treated as having a capital gain while you get ordinary income from the sale? Of course not. You all have a capital gain.

Let’s say you actively manage your investment portfolio. This active management is your labor. But the products of that labor—gains and losses—are treated as capital gains and losses.

In other words, the distinction between capital gains and ordinary income across a whole variety of activities does not turn on whether it is a gain from investing financial capital or from contributing services and labor. There are lots of gains through services that get taxed at the capital gains levels.

There may be arguments in favor of treating the carried interests of hedge fund managers as different from the paid-in interests of hedge fund investors—but this phony distinction between gains from “capital invested” and gains from “services” isn’t one of them.

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