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.
Reihan:
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.
The above assertions are not true in the least. The proposal is to redefine carried interest as ordinary income.
It has nothing to do with capital gains themselves. Deli owners, franchisees, etc that invest their capital into a business will be able to use the capital gains rate the same way they alway have.
Furthermore, the idea that “carried interest” is “sweat equity” is laughable. These are bonus payments based on performance. The fund manager, venture capitalist or private equity partner has made no investment of their own capital. They are being paid work for hire the same as anyone else.
It is certainly possible that some funds will attempt to redefine their bonus structure to provide more equity compensation to their managers, but that will be dealt with in all the same ways equity compensation is deal with. No problem there.
— talboito · Nov 18, 09:10 PM · #
Taliboito:
In response to the post, you say that:
“Furthermore, the idea that “carried interest” is “sweat equity” is laughable. These are bonus payments based on performance. The fund manager, venture capitalist or private equity partner has made no investment of their own capital. They are being paid work for hire the same as anyone else.”
In my view, you are correct that carried interest represents compensation received for work, rather than for investment of cash or tangible assets. (A slight complication that can be ignored for the purposes of this discussion is that most General Partners actually do contribute some capital to the fund) I think, however, that you are missing a key point. Lots of kinds of compensation for labor are taxed at capital gains rates. This is because some compensation for labor is in the form of equity or forms that are, in effect, equity.
Consider three people:
A goes to work at a job and gets paid a salary of $50 per year plus a variable annual performance bonus that turns out to be $50. This is all taxed as ordinary income.
B goes to work at the same company and gets $50 in salary that is taxed as regular income plus stock options in her company that, after several years, she sells for a $100 profit. This $100 is taxed as a capital gain.
C starts a company using cash from a venture capital fund, while investing none of his own money. The VC gets 80% of the equity and the founder retains 20%. The founder draws no salary. After several years, the company is purchased for cash. His share of the equity nets him $100. This is taxed as a capital gain.
To use the terms of your comment, B and C “made no investment of their own capital. They are being paid work for hire the same as anyone else.” Exactly – they are getting sweat equity. This is what sweat equity is: compensation for labor in the form of equity. Hence the name.
Notice that none work for a hedge fund.
Here’s (a simplified example of) how carried interest works for a typical private equity fund. The Limited Partners (LPs) put in $100. The General Partner (GP) – we’ll call this person D – puts in no money, but runs the fund in return for a 20% carried interest. The fund pays D $2 per year in management fees. This $2 is taxed as ordinary income. The fund buys an operating company for $10 and sells it several years later for $110. The $100 profit to the fund is split $80 for the LPs and $20 for D. The $20 gain for D is taxed as a capital gain.
What if instead of establishing a partnership with an LP/GP structure with a carried interest for D, instead they just bought the company, hired D as an executive, paid him $2 per year of salary and gave him options equal to 20% of the shares with a strike price equivalent to a value for the purchased company of $10? D would be taxed for the $2 annual salary as ordinary income. Upon the sale of the company, D would then net $20 from his options, which would be taxed as a capital gain. Sound familiar?
Now, as I said in my post, I understand the philosophical perspective that says A, B, C and D are just being paid for labor, and therefore all should pay the same tax rate on cash receipts. I also understand the alternative philosophical perspective. I wasn’t trying to adjudicate the “fairness” of this at all.
My point was only that if you try to tax one form of “equity” compensation named “carried interest” at 35% and others at 15%, the guys who currently operate investment funds are not simply going to roll over and pay 35%. They (or more precisely, the best tax lawyers in the world, whom they employ) are going to figure out how to structure their investment vehicles as one of the other ownership forms that allows them to pay the lower tax rate on what is currently called “carried interest”, but will then be called some other name. Therefore, ultimately you either have to go all the way and eliminate all capital gains tax treatment for labor, or else accept that this “reform” will merely generate some legal fees plus force investment funds into somewhat less efficient formats.
— Jim Manzi · Nov 19, 07:35 AM · #
You lay out a scenario where someone’s “sweat equity” compensation is similar or same to their “carried interest” compensation. Fine.
I have a few quibbles with the scenario, but I’m sure you could rejigger whatever might need rejiggering. I don’t doubt that those smarty smart private equity types will find a way to get paid.
But the point at issue is “carried interest”.
Although you claim “I wasn’t trying to adjudicate the “fairness” of this at all.” The “carried interest” issue demands your judgment. Mine says it is not fair for anyone to take a capital gain on income that was not at risk.
— talboito · Nov 19, 10:44 AM · #