Carried interest and capital gains tax concessions

There is a raging debate going on about whether publicly traded partnerships in the US should be given concessionary treatment on taxation. "Carried interest", the focus of this attention, is the tax levied on partners for the profit earned by them, while managing the assets of other individuals.

In such partnerships, the managers usually operate as a partnership, representing the general partners running the PE firm or hedge fund. The general partners run the PE firm on behalf of the limited partners, who are the high net worth investors. Typically the general partners put up about 5% of the capital, and get an annual fee of 2% of assets under management for management services and 20% of the cumulative profits on the investments. The former is taxed as ordinary income, while the latter, called "carried interest", is classified as long-term capital gains and taxed only 15%.

According to the existing taxation rules in the US, private and publicly traded partnerships are required to pay long-term capital gains tax of only 15%, as against the regular corporate tax rate of 35%. This tax benefit is an extension of the long term capital gains tax concessions given to investors in financial equity. Critics point out that there is a significant difference between private investors (limited partners) and the general partners of PE firms and hedge fund managers. While the former are risking their own capital, the latter are managing the assets of other people. They are not risking their capital, and are paid for their expertise (this is itself a moot point!) in managing these assets with 20% of the total profits made by the Fund. If this logic were to be extended, any employee of a Pension Fund or Mutual Fund ought to be extended this tax concession.

In early June this year, Senators Max Baucus and Charles Grassley introduced a legislation to remedy this anomaly, aimed at publicly traded partnerships like the Blackstone Group (informally dubbed Blackstone's law). The law, if passed, would ensure that publicly held partnerships would also pay taxes as an ordinary corporation rather than as a partnership.

This debate has also generated a demand that even the privately held partnerships like the massively profitable private equity firms and hedge funds, should also pay the regular corporate tax. Those in favor of scrapping any tax benefits argue that there is no reason why partnerships should get a benefit which is denied to an entrepreneur. There is also the contention that "carried interest" is a component of management fee and is not a capital gains, since the overwhelmingly major share of investment is by the limited partners.

Paul Krugman argues in his New York Times column, "Why does Henry Kravis pay a lower tax rate on his management fees than I pay on my book royalties?" Krugman hits the nail on its head. Increasingly, with massive leveraging, the share of proprietary capital in the total investments of private equity firms, are a small proportion.

One of the fundamental principles of taxation is that it should be fair and economically efficient. This means that effort and not luck needs to be our central concern and it should be rewarded appropriately. I have an issue here with not just the tax concessions given to private and publicly traded partnerships, but with tax benefits on capital gains itself. A detailed elaboration of this position in the next post.

Update 1 (5/4/2010)

The annual survey by AR: Absolute Return +Alpha magazine finds that the top 25 provate equity and hedge fund managers earned $25.3 billion in 2009, including fees and capital gains. Leading the pack, David Tepper of Appaloosa Management made $4 billion, in part by betting successfully that the government would bail out the big banks. John Paulson, of Paulson & Company, made $2.3 billion by buying back bank stocks he shorted in 2008. And a year after his fund received $200 million in the bailout of the American International Group, Kenneth Griffin of the Citadel Investment Group made $900 million.

Some hedge fund managers and, more commonly, private equity fund managers are able to pay a much lower rate of tax, as capital gains tax, than the typical working professional. The tax disparity results from an outdated rule that lets a money manager in a private partnership treat a chunk of his fees as if they were long-term capital gains, taxed at a special low rate of 15%. It has been argued that fees for managing someone else’s money should be taxed as ordinary income, like wages and salary, at rates as high as 35%.

President Obama has included a provision to end that special treatment in his most recent budget. For three years running, the House has passed a bill to close the loophole. In the Senate both Democrats and Republicans have resisted, all for fear of losing lucrative campaign donations.