As Congress gets set to return from August recess, the business world and the stock market are all atwitter about the prospects for true, comprehensive tax reform. Tax reform should be a once in a generation opportunity to transform the tax code from an outdated relic of economic burden into an incentive-based system that rewards risk taking, entrepreneurship, and innovation. It should be.
A word to the wise: beware of Congress playing games with taxes, particularly the budget “neutrality” shell game. Before Congress agrees to cut taxes, it always seeks first to raise them on someone else, all in the name of some sort of contrived budget “neutrality.” Thus, members of Congress are always on the lookout for some “undertaxed” honeypot to drain in order to fund their personal pet tax cut.
One potential honeypot everyone has their eye on is the current treatment of carried interest as a capital gain, rather than individual income. Wait, what’s carried interest, you ask?
The reason most people don’t know is because carried interest applies only to the world of investment pools, such as private equity and hedge funds. Private equity funds acquire ownership stakes in other companies and seek to profit by improving operating results or through financial restructuring. Hedge funds follow many strategies, investing in any market where managers see profit opportunities.
These types of funds are generally structured as limited partnerships: the fund managers act as general partners, while the outside investors are limited partners. The general partners generally offer the venture management expertise, while the limited partners provide the bulk of the capital (although general partners also invest capital, generally less than 10%). General partners are compensated in two ways. First, to the extent that they invest their own capital in the funds, they share in the appreciation of fund assets; as the funds grow, so too do their initial investments. Second, they charge the outside investors two kinds of annual fees: a percentage of total fund assets, and a percentage of the fund’s earnings. The latter performance fee is called “carried interest” and is treated as capital gains under current tax rules.
The carried interest provides powerful incentives to align the interests of the partners. While the general partners receive a management fee that covers administrative overhead, operating costs, and managers’ salaries, that fee is fixed and does not provide incentives to improve the performance of the real assets. When the general partner has his or her own money invested in the performance of the fund, he or she has a vested interest in the venture’s success.
For the past 50 years, the profits from carried interest have been taxed as capital gains rather than ordinary income for several reasons. First, private equity managers, unlike hedge fund managers, tend to make long-term investments, those lasting longer than one year. Carried interest, which is not realized and taxed until the sale of the fund, represents a long-term investment. Because the tax code is structured to reward deferred consumption over immediate consumption, capital gains, e.g., long-term investments, savings, have historically been taxed at a lower rate than ordinary income, such as wages or the management fees paid to general partners.
Second, carried interest represents another virtue we reward in America: risk-taking. The private equity industry is based on risk; contrary to what Bernie Sanders and Elizabeth Warren seem to think, not every deal results in profits that are just waiting to be taxed and spent. That is why we reward the firms that help companies raise money without resorting to the public financial markets. We encourage the Bain Capitals that restructure troubled companies and launch successful new ventures like Staples – even if we don’t vote their leaders into the White House.
Those who want to change the tax treatment of carried interest argue that private equity firms generally don’t have much of their own money at risk — that the burden of capital risk is borne by the limited partners. This discounts the value of “sweat equity,” as illustrated by Kevin Williamson in National Review:
If you open a dry-cleaner business and your rich uncle invests $20,000 in the project to get you started, the profit you realize 20 years later when you sell your successful chain of cleaners is treated as a long-term capital gain for tax purposes, in spite of the fact that you didn’t have any of your own money at risk. You didn’t invest money: You invested time, work, knowledge, and innovation, and you bore the opportunity costs for all the other things you might have done with your time and labor. You are every bit as much of an investor as is a guy who buys 20 shares of GM and parks them in his retirement account for 20 years. More of one, some might say.
Whatever the arguments made by opponents of carried interest (primarily Democrats, but including, for some reason, President Trump), their primary desire is revenue. By labeling private equity as a pastime of the “rich,” they are using the tired, old wealth redistribution argument to fund their own pet projects.
Tax reform is an opportunity to unshackle the economy and unleash the power of entrepreneurs and risk takers to restore vibrancy to our business and job market. Raising taxes would do just the opposite.
Longtime Senate Finance Committee Chairman Russell Long used to say, “Don’t tax you. Don’t tax me. Tax the fellow behind the tree.” Right now, one of those fellows is the tax treatment of carried interest, and there’s good reason to hide. As long as there are Elmer Fudds in Congress searching for tax increases to finance their pet tax cuts, tax “reform” season is always “wabbit” season. Beware!