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Friday, October 28, 2016

Carried interest, the share of profits that private equity fund managers receive, is currently taxed at the capital gains rate, but it should be treated as standard compensation.

In recent months, there has been a growing consensus that the tax code is broken and must be reformed or overhauled. Unfortunately, that’s where the consensus ends. Politicians are loath to eliminate provisions that garner them support, and the result is that the tax code is riddled with small loopholes that end up costing big bucks. One of the failures of the tax code is the unequal treatment of similar activities, such as the tax treatment of carried interest. Although only a few people even know what carried interest is, this provision costs the government around $1.3 billion annually. That’s a big break for just a few people. The fault lies not with the individuals who take advantage of these provisions, but rather with the legislators who enacted them and today, fail to eliminate them.

Taxation of carried interest has been around since the implementation of subchapter K of the Internal Revenue Code, which governs the taxation of partnerships, in 1954. Though part of the tax code for over half a century, the taxation of carried interest only became a hot-button subject recently, when private equity firms and hedge funds rose in prominence in the financial sector.

Private equity and hedge funds manage an estimated $1 trillion each, and private equity raised around $240 billion in capital in 2006. With such a large amount of assets under management, legislators and policymakers have taken a closer look at the taxation of their earnings.

Carried interest (or profits interest) arises as part of a partnership arrangement. When a private investment fund is formed, it usually comprises two types of partners. Limited Partners (LPs) contribute capital to the investment fund. General Partners contribute knowledge of investments, some capital (usually 1-5 percent of the firm’s assets) and manage the funds on a day-to-day basis. It is important to note that partnerships are pass-through entities, meaning profits are not taxed at the partnership level, but rather each partner is taxed individually.

General Partners are paid a management fee, usually around 2 percent of the fund’s assets, for the day-to-day operations they oversee. This management fee is taxed at the ordinary income tax rate. When the fund turns a profit, LPs usually receive 80 percent of the profits (called capital interest), and GPs receive around 20 percent of the profits, sometimes not until a profit threshold (say, 7 or 8 percent) is reached. The share of the profits that the GP receives is called carried (or profits) interest, and is currently taxed at the capital gains tax rate.

Most private equity funds have a lifespan of 5-7 years, so the income gained during this time is applicable for favorable long-term capital gains tax treatment, as opposed to hedge funds profits, which usually constitute short-term capital gains. Both long- and short-term capital gains rates are lower than traditional income rates.

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  • gmccpa

    Other items that should not receive favorable capital gains rates are capital gains and dividends on foreign investments, as well as commodities. The purpose of the favorable rates is to encourage investment…but it should be American investment, where it creates jobs. American jobs…not jobs in China and India. Isn’t that the big issue? And neither foreign investment, or stockpiling gold bars achieve that goal.

    • charleo1

      You’re spot on. The question is, why hasn’t the law changed to reflect the
      new realities of investments? One reality being, on average the investment
      made overseas delivers 3X the return, because of wage disparities. And
      that is not the only way the tax code incentivizes foreign investment. Uncle
      Sam is still allowing write offs for the expense incurred when a company
      transports it’s equipment, and operations abroad. This one loophole alone
      has contributed to the loss of more than 10 million manufacturing jobs in
      the first decade of the new millennium. Yet, the Party of No. The constant
      and unwavering friend of corporations, and the monied elite, refuse to
      consider modifying on syllable of the current tax mess. For fear Grover
      Norquist would see it as raising taxes. To be perfectly clear about Grover.
      He doesn’t have a problem raising taxes on the Middle Class, and working
      poor. Because he sees these people as needing to support to a much
      larger extent, the social safety net programs. Which, in his eyes, don’t
      benefit the wealthy.

  • charleo1

    Just a few years ago, in the depths of the recent recession, I commented what I
    thought to be a fairly benign, and commonly accepted, fact of life. That everyone
    knows the rich have been getting away with murder in the tax code for years.
    Immediately I began to receive these extremely over the top slap downs for
    suggesting the wealthy were doing anything but struggling aganist the high burden
    of over-taxation. And that furthermore, it was the ever growing welfare dependent
    under class that was the culprit. Posting under names associated with the Taxed
    Enough Already, Party. Supposedly a grass roots campaign aganist government
    tyranny, inflicted through the tax code on the productive, read, wealthy class.
    So I thought, how incredible that we have these work a day people, who actually
    pay very few Federal Taxes themselves, using words like wealth redistribution.
    In spite of the fact, the wealthiest 400 people hold more money, than the lower
    50%, of the entire population of the U.S. combined. This, what I consided jaw
    dropping, phased this crowd, not in the least. On they continued, apocalyptic
    about the increasing number of lazy shiftless moochers, who paid no tax at all!.
    To which I thought, pointing to an increased in the number of people qualifying
    for government assistance, in the worst patch of hard times since the Great Depression, was not only disingenuous, cynical, and mean spirited. It completely ignored the facts.

    • Dominick Vila

      In addition to having one of the lowest tax rates in the industrialized world, we also have enough loopholes, laws that provide tax exempt status for individuals that invest abroad, tax exempt status for political and religious organizations, and we look the other way when the wealthiest members of our society deposit much of their wealth in the Cayman Islands or Switzerland. Interestingly, if a single Mom working as a waitress to support her kid (s) does not file on time or does not reports all her earnings, the IRS comes down on her immediately. The system is designed to help the wealthy accumulate more wealth under the pretense that if they become richer they will invest at home and we will get a few crumbs here and there. It hasn’t happened and never will. The rich invest their earning where the highest ROI is almost guaranteed, they shop in Paris or London, and vacation in Bali.

      • TZToronto

        Of course they shop in Paris and London and vacation in Bali. They certainly don’t want to have to endure the company of the ordinary American. They much prefer the company of the wealthy from other countries who shop in Paris and London and vacation in Bali.

        • charleo1

          Well. La Te Da!

      • charleo1

        I think you summed it up very well. I have ask, but so far have not
        gotten an answer, as to what point the wealthy, and corporations
        will have accumulated enough money, so the trickle down can
        start? Evidently the top 400 having more money than the bottom
        50% is not enough. So, when? When these same 400 have more
        money than 3/4 of everyone else? I’d guess not, because that
        would mean there is still 1/4 out there someplace that they must
        have in order to make investments. And then! Boy Howdy, it’s
        going to float everybody’s boat!

        • Independent1

          Charle, it’s really something to realize 400 families in America who represent only .0000035 percent of all households in the United States has amassed 1.27 trillion in wealth while the bottom 160 plus million people only has a combined wealth of 1.22 trillion. And despite that, the top 400 would probably feel the same, even if as you say, they had more wealth than the bottom 250 million Americans combined. Clear evidence of just how incredibly greedy people can be!!!!

  • bckrd1

    This is definitely correct. I hate that this is allowed and it it wrong, wrong, wrong to continue this.

  • George Allegro

    Within an impersonal modern civilization, we serve and are served by those we don’t know and whose very existence we will likely never know.