Should Carried Interest Be Given Preferential Tax Treatment?

Tax on carried interest

Carried interest are a share of the profits retained by hedge and private equity funds. We treat these profits as capital gains although many think they should be taxed normally.

The concept of carried interest is believed to have originated with sea captains centuries ago, who were provided a 20% stake in the shipments they transported to compensate them for their services as well as the risk they took on with the project.

Paying shipping lines this way may strike us as odd or excessive nowadays, but this model lives on with hedge and private equity funds. The funds charge a nominal management fee like other funds do, usually 2%, and a certain return is promised, which is set at the benchmark. These benchmarks do vary but they generally are set at a level that investors would otherwise be very pleased with, in other words, very competitively.

Should the fund exceed this benchmark, they get to retain a certain percentage of the excess profits they generate, which can range up to 44% in some cases but are usually in the 15-20% range, with the 20% that sea captains used to charge being typical. We refer to this generally as the 2 and 20 rule, where you pay 2% on the entire amount and 20% over the benchmark.

We afford preferential tax treatment to capital gains, which is distinguished from what we consider ordinary income due to wanting to encourage more investment. The salary that you earn or even the bonuses that you are paid are considered ordinary income, and are taxed at normal rates, where if you invest some of the money you make in stocks or other investments, the money you earn may be taxed at the lower capital gains rate.

Should the money that funds earn from carried interest be treated as ordinary income, due to it being earned by way of skill and not capital directly, or should it be treated the same way capital investment is, at a lower rate?

This has been a debate that has been going on for quite a while now, particularly since we’ve seen private equity funds explode and now control over $5 trillion in assets. While private equity firms have been a favorite punching bag for left-wing democrats, even President Trump opposes this favorable tax treatment, believing that these firms get away with “murder” with this.

When Elizabeth Warren and Donald Trump oppose something, you can bet that the opposition is pretty widespread indeed. President Obama was on this list as well, and campaigned against this, although a compromise ended up being reached where a 3.8% surcharge was added to the normal capital gains due.

This did close the gap but given that the ordinary tax rates that apply are almost twice that of capital gains tax, in the neighborhood of 40% instead of 20%, this surcharge only narrowed the gap by a relatively small amount.

We Need to Look Closely at the Ultimate Costs and Benefits of Such a Change

According to the Treasury Department, there still exists a gap of about $11 billion if this so-called loophole was closed, and this is a large enough number to still have people eyeing it. It’s not so much that $11 billion would make all that much difference to the treasury, it is the principle involved that upsets people the most, the fact that some very wealthy people are seen to benefit from this tax treatment exclusively.

Whether this would result in this $11 billion extra in the treasury remains a big question though, and it is very likely that this number would be much smaller after firms respond to these changes and seek other ways to lower their tax bills.

With Trump’s tax bill, a compromise was struck with members of Congress where the minimum term of these investments in order to qualify for capital gains treatment was extended from one year to three. Private equity firms generally hold assets for longer than three years so this really didn’t have much of an effect upon them and their lobbyists came out looking as good as perhaps could be expected this time around.

Money earned through these performance fees are certainly distinct from normal capital gains, but they are also distinct from earned income generally, and fall into a grey area which is the source of all this debate. In order to make an informed decision, we can’t just look at how much money these firms make from performance fees and just want them to pay more, we need to look at the actual merits of changing this rule would be as well as the consequences of such a change.

All taxation, by its nature, inhibits economic growth to some degree, although we still need to raise money through taxes. We therefore must seek to properly balance the needs of government funding through taxation with the needs of the economy as a whole, on top of any considerations of fairness that may emerge.

Ideally, from an economic perspective, we would target only earned income and not capital gains, because restraining the use of capital is particularly limiting on economic growth. Capital gains that are removed from the total pool of capital cannot grow further, and this is especially noteworthy with capital that is being used for direct investment into businesses.

Instead of taxing capital gains at the full normal rate, we have struck a compromise where the amount of tax owing is less, and this is not done as a special favor to the wealthy but to strike a balance between funding the government and encouraging investment.

The question then becomes whether or not carried interest is more like capital gains or ordinary income. The claim on the side of those who want to understand this as ordinary income is that if this were paid out as a bonus, like a banker might earn for generating investment income for his or her clients, then this would clearly not qualify as capital gains as it would consist of reimbursement from an employer.

Carried interest is different though as it is a direct capital distribution from capital gains. The client receives it the same way and reports it as capital gains on their taxes. The fund company gets 20% of this amount to keep for themselves and it’s out of the same distribution as what the client receives.

Clients do earn this from their capital but we can also consider the management of their funds as a form of capital, although non-monetary. While we can make a distinction here, we need to ask if it is a meaningful one as far as the intent of the capital gains allowance is concerned.

Both the monetary capital and the intellectual capital of the firm serves to stimulate investment, and if not for this arrangement, if we did not allow such things and the investors put their money in the stock market instead, that only is an indirect stimulant. While investing in stocks does provide more liquidity to the stock market, by the time we get to invest in a stock, the company has already been paid for the stock and all we really do from there is trade these shares back and forth between ourselves, which has no direct bearing on the business world.

Private equity investment is different though and this does impact the business world fundamentally, by its very nature, so this sort of thing is actually more impactful to business and the economy than trading stocks are, and that’s exactly the sort of thing that we’re looking to promote with this preferential tax treatment.

We still could get rid of this though because this is still within the prerogative of legislators, although we still need to carefully consider the consequences of this, as Treasury Secretary Henry Paulson reminded Congress back in 2007 when they first considered scrapping this provision.

The estimates for the amount of tax revenue that taxing carried interest like regular income would provide ranges widely, anywhere from $1 billion to $18 billion, and this is because private equity firms aren’t just going to sit back and take this. The main reason why these companies are structured as partnerships is to take advantage of this tax break, and if you take it away, you can bet that they will be seeking other means of tax efficiency.

This Idea Would Stifle Investment and May Even Reduce Tax Revenues

Hedge funds already do a lot of this and in addition to having their carried interest treated as capital gains, they also set up reinsurance businesses in Bermuda, which does not have corporate income tax, all within the law, where they divert huge amounts of money to. If we ever do get rid of this tax benefit, you can bet that a lot more ships full of loot will be setting sail and this means less and not more money for the treasury.

A few years ago, when the talk of getting rid of this became particularly loud, several firms were already scurrying to implement their plan B’s. If any firm did keep their present structures intact, we also have to ask who will bear the brunt of this extra taxation, and it’s actually naïve to think that the firm would. Rather, any additional expense would likely be passed on to investors, at least partially if not the entire amounts.

The world of private equity is as far from being commoditized as you can get, and there already is a wide range of percentages used among firms for carried interest, and once investors get their 8%, they are often happy with whatever percentage they get on the remainder. Most or all of this tax, or in reality, most or all of the additional tax they may pay after they alter their tax structures will likely come out of not their pockets, but out of the pockets of the investors that they serve, including a lot of pension funds and endowment funds.

Donald Trump may think that these firms are getting away with murder, but once you get into the carried interest part of this where this becomes an issue, both investors and firms get pretty happy, and no one gets murdered.

On the contrary, the use of this money can breathe new life into distressed companies and take others to the next level by providing both with either the capital they need to expand and improve or perhaps even to survive and save a lot of jobs.

We still need to get over the anger that so many of us have toward the very rich, and this not only benefits business but does make some people very wealthy indeed by their leveraging their skills to help businesses, their investors, and themselves as well. The fact that a few people make a lot of money cannot be the primary consideration here as we need to consider the overall picture as well.

More taxation on this form of investment will very likely mean less money available to help companies, resulting in both missed opportunities in business and in investment. If any violence actually goes on with this, it will be legislators looking to beat everyone up over this for the sake of trying to squeeze more tax dollars out of all this then it would be prudent to look to extract.

Carried interest continues to dodge the bullets so far, but we still need to hope that our politicians will continue to get enough good advice to prevent them from looking to constrain this form of investment unduly. No one has really come up with a way to make sense overall out of shutting down this so-called loophole, and it’s even hard to imagine how we could, given that this won’t raise much more money at all and the damage we cause will certainly be greater than these benefits.

Regardless, we need to tread carefully when we look to subdue investment, actual business investment that is, and it’s never just a matter of pulling out your gun and holding out your hand, because when the economy is concerned, things are never just that simple.

Monica

Editor, MarketReview.com

Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.