Carry Me Back to Old Greenwich

By :: October 15th, 2007

There has been talk in recent days that the congressional effort to raise taxes on the earnings of private equity managers has been killed. Don’t believe it.

The Washington Post’s Jeff Birnbaum reported on Oct. 9 that Senate Majority Leader Harry Reid (D-Nev.) has decided to deep-six the bill following a multi-million dollar lobbying campaign by the financial partnerships. But House Ways & Means Committee Chairman Charles Rangel (D-N.Y.) remains committed to using money raised by a tax hike on private equity managers to help pay for alternative minimum tax relief. And don’t bet against Rangel when both issues are thrown into a last minute, end-of-session omnibus money bill sometime in December.

To the amazement of tax policy experts all over Washington, the exquisitely complex dispute over how to tax "the carry" has become the issue de jour. Depending on who you talk to, carried interest is either the compensation that the general partners in private equity and hedge funds earn for doing their deals, or it is a return on their investment. Thus, it should either be taxed as ordinary income at 35 percent or as capital gains at 15 percent. There are big bucks involved here, but there are also some very important tax principles at stake. The Tax Policy Center's Gene Steuerle did a nice job of putting this mess in perspective in his testimony before the House Ways & Means Committee on Sept. 6.

To help understand what the debate is about, imagine a large financial services firm: At one desk sits a 26-year-old Harvard MBA who is beavering away as an investment banker. Across the hall, his classmate is doing private equity deals. Their work is indistinguishable. Yet the income generated by the banker is taxed at 35 percent while income produced by private equity deals is taxed at 15 percent. It is hard to work up much sympathy for investment bankers these days, but this seems to be a textbook case of what has gone wrong with the tax code.

Since the protagonists can't agree on what the carry is, it should be no surprise that they can't agree on how to tax it. Those who believe it is compensation argue that it should be taxed as ordinary income, just as it is for the bankers. University of Illinois law professor Victor Fleischer laid all this out at the Ways & Means Committee.

By contrast, Bruce Rosenblum, Managing Director of The Carlyle Group, and Chairman of the Board of the Private Equity Council, told the Ways & Means Committee that private equity firms are no different than the entrepreneurs who create companies. True, the buy-out specialists are making an underperforming asset profitable instead of starting a business from scratch. But they are creating value where there was none before and, thus, the returns to both their capital and their sweat equity should be taxed as capital gains.

To sort through this, it helps to understand how the managers of private equity firms get paid: They get a base fee of 2 percent, plus 20 percent of any profits after investors earn an agreed-upon return. Taxes on the 20 percent (at least) are both deferred and subject to the sweet 15 percent capital gains rate.

The problem is the law never contemplated these kinds of arrangements. So, we end up with tax policy as simile. Fleischer got to the heart of the dispute during a Sept. 7 TPC forum: Are these investors acting like bankers who are taxed in full, or do they function like entrepreneurs who enjoy the capital gains preference?

And, whatever they are, does their work deserve a special tax break? Supporters of low rates argue that the tax code should encourage risk taking. But, the after-tax rewards to these transactions are very generous, even if they are taxed at a 35 percent rate. The industry itself claims that the top 25 percent of private equity firms returned more than 39 percent per year to investors from 1980 to 2005. University of California at Berkeley professor Alan J. Auerbach estimates the extra tax would trim those returns by just 10-20 basis points (0.1 percent to 0.2 percent). That’s not likely to be a deal breaker. And if it is, maybe the deal isn’t worth doing.

Backers of the low cap gains rate have a tough sell. On Capitol Hill, they’ll have to overcome the fairness argument--it just doesn’t seem right to many politicians that rich guys who earn 20 percent or more by sitting in Greenwich, Conn. and investing other people’s money should get a tax break too. But there is more than just populist politics going on here. Good tax policy says if you do the same work, you should be taxed the same way. And whatever private equity managers call themselves, they are investment bankers and should be taxed as such. If it walks like a duck.... 


  1. Anonymous  ::  2:37 pm on October 16th, 2007:

    “Good tax policy” has nothing to do with this fight.
    “Good tax policy” would recognize that there is an integration between the corporate and personal income taxes, and treat labor and capital income equally.
    Corporations are allowed a deduction for wages, so wage income is fully-taxable personally. However, corporations do not get a deduction for dividends, and cannot get a deduction for capital gains. Yet, this after-tax corporate income is double-taxed on the personal level, albeit at lower rates.
    The “good tax policy” here would be to tax qualified dividends and corporate-source capital gains at 0% personally, and tax everything else at full marginal tax rates.

  2. Anonymous  ::  4:31 pm on October 16th, 2007:

    “Backers of the low cap gains rate have a tough sell. On Capitol Hill, they’ll have to overcome the fairness argument–”
    Backers of changing the law have a tough sell. While Congress sometimes has “fairness” on the stove it is seldom on the front burner. (Nor is consistency in the tax law a front burner item.)
    Only if members of Congress consider the threat of lost votes to exceed the threat of lost campaign contributions will the law be changed.

  3. Anonymous  ::  8:41 pm on October 16th, 2007:

    I will return to the carried interest issue, but first let me say that all income should be taxed alike. Favorable taxation of capital gains is unjustified, except perhaps as a way to artificially inflate the stock market. Investors need to invest their money; they don't need a tax incentive to do so. Any tax incentive should go to those who make productive use of capital,not those providing it. As a policy matter on what the tax law should be, rather than is, the private equity managers have a better claim to the capital gains tax break than the passive investors. More important in my view is that my grocery store clients will pay a 15% tax on the return on their investment if they invest in WalMart but a 37.9% tax (including the Medicare tax) if they reinvest in their own business.

  4. Anonymous  ::  12:52 pm on October 17th, 2007:

    Now to the carried interest question. One of the oldest uses of the partnership is to joint together two partners – one who provides capital and the other services – and then share the profits from the enterprise. The only reason that the tax writing committees are viewing a change in the rule for carried interests is that tax “politics” has replaced tax “policy” – sorry for the timing of your blog.
    Let's consider a more appealing political group than venture capitalists — farmers. Phil Farmer has not children to take over his farm so he offers a partnership to Grad Young, a recent college graduate in Agriculture. Because Grad grew up in the city, he had no family support to start in farming. Grad and Phil agree to share all profits 75/25. Some commentators argue that Phil has taxable income on creation of the partnership: if adopted this position would preclude the creation of the partnership as no cash is available to pay the tax. Unfortunately the partnership did not work out and it had to be liquidated. While Phil and Grad operated their partnership, the value of the farmland appreciated by $100,000. In accordance with their agreement, Grad was allocated cash of $25,000 and capital gains of an equal amount. Some commentators believe that Grad ought to have earned income. However, if Grad had not partnered with Phil but rather borrowed the money to start his own farm, he would have had capital gains. So why should he have ordinary income from the partnership?
    The same is true of the carried interest. IF the GP's borrowed the money and then invested it in the fund businesses, they would have capital gains income rather than service income. A few commentators have focused on this fact and the related fact that the carried interest could be restructured as a non-recourse loan to avoid the proposed carried interest tax changes to suggest that interest should be imputed on the 20% capital represented by the carried interest. Of course, imputing interest at the AFR does not generate much revenue, making the change less attractive politically.
    The carried interest debate is an example of tax policy only if you agree with Lee Sheppard of Tax Notes that taxing the rich is a tax policy. Just repeal the capital gains differential.

  5. Anonymous  ::  4:56 pm on October 17th, 2007:

    The Tax Doctor. There are two taxing variables: the AMT and campaign contributions. The former fluxes the taxing parameters as the tax systems morphs from its double tax entendre into a permanent AMT. The latter appears to have significant inhibitatory implications.

  6. Anonymous  ::  3:08 pm on October 19th, 2007:

    Your topic reminds me of another proposal that I wonder whether it has been thrown under the bus of political impracticality– the windfall tax on oil companies. Thoughts?