I Was Glib About Carried Interest

Consider this a guest post from our friend Jim Manzi, who very politely unravels a half-baked argument I praised below on.


I’ve learned the hard way not to make assertions about tax law after skipping the three years of law school where you’re supposed to cover stuff like this, but I do have a question: how could you contain the change in the treatment of carried interest to “hedge funds” vs. every other form of sweat equity?

It doesn’t seem like it would be hard to replicate the 20% carried interest structure through a regular C-corp using the layers of debt, preferred equity, common equity and options that are used in pretty much every tech (and non-tech) start-up in the US. “Sweat equity” is basically any ownership that I am granted in the business over and above what I get in return for my pro rata contribution of tangible capital because of my contribution to creating and/or building the business. This sweat equity can be provided in multiple formats, for example Founder’s Equity or options in a C-Corp. “Carried Interest” in a hedge fund has a very similar economic structure to options in a corporation. Similar corporation or partnership structures are used for pretty much every small business and professional partnership in the US. They all have investors and have the ability to sell the ownership of the business for more than was invested, thereby creating a profit to the owners that will be taxed at some rate.

Unless I’m missing something, all I have to do is re-label my “hedge fund” as something else and I force the government to either convert the tax treatment from capital gains to ordinary income for anybody with sweat equity in this kind of vehicle, or let me get capital gains tax treatment on my “carried interest”, which has now simply been re-labeled as Founder’s Equity, option value or something else. At that point, how would you distinguish between a hedge fund and any business? It’s based in Greenwich? The guys drive expensive cars? I’m sure there are regulatory, investment management and other material efficiencies uniquely available to me as the fund manager under a hedge fund structure, but I bet I’d trade them away for having my profit taxed at 15% instead of 35%.

The net effect of such a law would therefore not be to take a bite out of hedge fund managers, but either be: (i) to make the same guys doing pretty much the same activities pay a little more money to lawyers and adopt less efficient vehicles for investments, or, ultimately, (ii) to treat all equity gains not linked pro rata to a cash investment as ordinary income – that is, to outlaw sweat equity.

Now, you might say “great, I consider all of this payment for labor, so it should be taxed at the same rate”, but if so recognize that you wouldn’t just be reducing the income of a few hundred billionaires – you’d be substantially reducing the profit available to the owners upon sale of any business. I suspect that the impact this would have on the owner of pretty much every dry cleaner, deli, car dealership, McDonald’s franchise and professional partnership in America might account for reluctance of Republicans to take this on.

As I said at the beginning, of course, there may be some obvious feature of the tax code that I’m missing that would create an impenetrable firewall between hedge funds and other businesses.

— Jim Manzi

To my embarrassment, I hadn’t really considered the wider impact of this “reform.” It’s stuff like this that makes me pine for a VAT.

I like to think that I make considered judgments about most issues, but in this case I left political affect get the better of me. Perhaps Republicans and some Democrats haven’t embraced the anti-Schumer stance because it is incoherent and it poses a much wider economic threat, which is to their credit. Granted, this leads to an unattractive outcome (what appears to be a “tax loophole”), but I suppose this is one of the costs of doing business in a competitive economy that encourages entrepreneurship. The benefits are sufficiently great to outweigh any outrage over Steve Schwarzman’s Croesian riches.

On a related note, last night one of my favorite writers expressed some disappointment that I find the Manzian argument on climate change persuasive: as an ardent Gristmillian environmentalist, he considers Manzi a far graver threat than the “it’s the water vapor!” crowd.