Sorry, Mr. President, Raising Taxes on Carried Interest Won't Work

President Barack Obama
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President Barack Obama

The Obama administration is once again proposing to raise the tax on the carried interest income that managers of hedge funds, private equity funds, and venture capital funds receive. Even if it were to pass Congress, however, the tax would likely raise far less than the Obama administration expects.

"Carried interest" is the cut of profits that fund managers get for running their investment vehicles. The size of the cut varies from fund to fund but it traditionally been 20 percent of the gains above some threshold.

Up to now, it's been taxed at the same lower tax rate as investment income, the capital gains rate.

The Obama administration proposes to tax carried interest as ordinary income. It's been argued by many people over the last several years that because the managers receive carried interest as part of their compensation for running the fund, it is equivalent to income.

This isn't a totally implausible argument. But just because it makes some sense doesn't mean changing the tax treatment will actually mean fund managers will pay ordinary income taxes on their share of the profits. It is incredibly easy to get around a tax on carried interest just by changing the way the compensation is structured.

I explained this last January in a post titled "How To Dodge a Carried Interest Tax Hike."

Step 1. Understand how carried interest works.

Imagine that you are running a private equity firm that will charge investors both a 2 percent management fee and receive 20 percent of the profits.

Your investor puts in $100 million under a three-year lock-up.

You buy a couple of troubled companies and then resell them. To make the math simple let's pretend you are the best private equity investor ever and you double your money.

The fund sees a 100 percent, $100 million gain from your investment activity. Your investor gets only $80 million of the $100 million in profits, plus his original $100 million. So he's got $180 million. An 80 percent gain after fees.

You take the remaining $20 million.

Both of you get taxed at the same rate—the capital gains rate.

Step 2. The law changes.

In order to end capital gains treatment for carried interest, lawmakers would classify it as ordinary income.

So now when your fund doubles the money, you and your investor get treated very differently. Even on the exact same $100 million gain, the taxes come out differently just because of how it is divided up.

Your investor still gets to call his profit a capital gain. But your share gets taxed at the higher income tax rate.

What's important here is not how the money was made—through investing in long term assets—but in who receives it.

Step 3. So you change your compensation structure.

Obviously, you are not going to simply accept being treated differently by the law just because you were the one managing the capital rather than the one supplying it. In fact, this seems a bit unfair: it rewards those who already possess wealth and punishes those who must raise it from others.

Instead of the old carried interest structure, you create a non-recourse loan.

Your investor puts up his original $100 million. Now only $80 million of that goes to purchase an 80 percent share in the fund. The remaining $20 million becomes a loan to you. You use the proceeds of that loan to purchase a 20 percent share in the fund.

Step 4. Divide the profits.

After a few years, you double your money again. So you have a $100 million gain, and a fund worth a total of $200 million. Your investor gets his original $80 million back plus 80 percent of the upside, which is $80 million. So he's got a total of $160 million.

You get your original $20 million investment back plus 20 percent of the gains, which adds up to $40 million in our example.

You pay back the investor the amount he loaned to you ($20 million.) That leaves you with $20 million in gains and the investor with $80 in gains.

You both pay capital gains taxes since both of you "bought" your share of the fund.

Step 5. Notice anything?

That's right.

A simple shift in the structure was able to restore the capital gains treatment.

And everyone ends up with exactly the same amount of money, regardless of how its structured.

Step 6. Why is it so easy?

The reason it is so easy is because carried interest really is properly a capital gain. Any attempt to tax it as ordinary income will just result in fund managers converting to a structure that makes the capital gain nature of the gain even more obvious.

The attempt to tax carried interest as something other than a capital gain will almost always fail as investors and fund managers agree to structures that taxes everyone's gain in the venture the same.

Now it should be possible to calculate an implied interest rate for the loan and tax the fund manager for the interest he isn't paying. But if you do that, you'll be raising a lot less than attempting to tax the entire carried interest as ordinary income.

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