T's for Taxes; T's for Tennessee -- Part III (Carried Interest)

We’ve tackled some pretty big tax reform ideas lately – we pined for the higher marginal tax rates and greater number of brackets under Reagan here, and talked about the tax break for the well-off known as capital gains here. So let’s address a smaller, less controversial idea today. 


In fact, today’s problem is so small … we’ve already solved it through our reforms on capital gains. But it will serve as a good lesson on how the privileged tax position of capital gains is exploited by the most well-off.

This loophole is known as carried interest, which is the

right to receive a specified share (often 20 percent) of the profits ultimately earned by an investment fund without contributing a corresponding share of the fund’s financial capital.  It is part of the standard compensation package for managers of private equity funds [and hedge funds, and a bunch of commercial real estate concerns as well]. 

Current law allows these managers to pay tax on all or most of their carried interest income at the 15 percent capital gains rate, instead of at the individual income tax rate that would otherwise apply, typically 35 percent for these high-income individuals. Rather than being taxed as managers receiving compensation for services rendered, recipients of a carried interest are taxed as though they were investors who had supplied 20 percent of the financial capital of the fund. 

If you’re a hedge fund manager, a typical compensation package might be a two-and-twenty – meaning that you would receive an amount equal to 2% of all the assets under management, as well as a 20% share of any profits – a performance fee. (Other factors – things like high water marks and expenses– will affect compensation, so this is a simplified version).

So let’s say you’re managing a small hedge fund with $100 million in assets. Because you are a very good manager, the fund makes $10 million this year. You will receive $2 million as your compensation, which will be taxed as ordinary income. But you will also receive 20% of $10 million, or another $2 million, as carried interest/performance fee. And this is the part which gets taxed as capital gains.

Why does this get taxed as capital gains? There's really no good reason. Proponents will argue that the 20% represents the gains that the manager would have received had he invested 20% of the capital of the fund. True ... but that's not what he did. The manager contributed ... nothing. Literally. 

The manager has provided a service, and he should be compensated (and taxed) for that. But in terms of capital ... the manager didn't add a single penny.

So how does this play out? Referring to our marginal tax rates chart:

2011 Taxes on $2,000,000
Marginal	Tax Brackets
Tax Rate	Over	But Not Over
10.0%	$0	$17,000	$17,000	$1,700.0
15.0%	$17,000	$50,000	$33,000	$4,950.0
25.0%	$69,000	$139,350	$70,350	$17,587.5
28.0%	$139,350	$212,300	$72,950	$20,426.0
33.0%	$212,300	$379,150	$166,850	$55,060.5
35.0%	$379,150	$2,000,000	$1,620,850	$567,297.5
				$667,021.5

2011 Capital Gains Taxes on $212,300
Tax Rate	Over	But Not Over
15.0%	$17,000	$2,000,000	$2,000,000	$300,000
		-
				$300,000

So the manager would have a total tax liability of $967,000. But if we recognized all of the $4 million as ordinary income, then his tax bill would be much higher.

2011 Taxes on $4,000,000
Marginal	Tax Brackets
Tax Rate	Over	But Not Over
10.0%	$0	$17,000	$17,000	$1,700.0
15.0%	$17,000	$50,000	$33,000	$4,950.0
25.0%	$69,000	$139,350	$70,350	$17,587.5
28.0%	$139,350	$212,300	$72,950	$20,426.0
33.0%	$212,300	$379,150	$166,850	$55,060.5
35.0%	$379,150	$4,000,000	$3,620,850	$1,267,297.5
				$1,367,021.5

Yes, we're currently giving tax breaks to hedge fund managers. We're that screwed up.

(For the sake of comparison, Topeka is now so broke that they're simply not prosecuting misdemeanors any more (including those for domestic violence).)

But as we noted earlier, this problem has already been solved. By taxing capital gains as ordinary income, this tax break simply disappears. It won't matter what the manager's compensation is called, or whether he made a capital contribution, because it will all be taxed the same.

Because income ... is income ... is income ... is income.

Disclaimer: The brackets above cannot be used to calculate actual tax liabilities without including other factors, most notably -- deductions. But they are indicative of tax liabilities over time, and between the well-off and the just-getting-by.