TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Sunday, January 13, 2013

NY Times: The Tax Code and the Very Rich

New York Times:  Explanations and Advice for Those Hit Hardest by New Tax Increases, by Paul Sullivan:

While the affluent will pay more in taxes this year, that is probably not the case for the very wealthiest — those worth hundreds of millions or more. They may still be paying a lower tax rate than Warren Buffett’s secretary.

Many millionaires are certainly paying at least 30% of their income in taxes, a goal President Obama set out in last year’s State of the Union address. But they’re more likely to be doctors, lawyers and people working in the financial services industry who get the bulk of their earnings in the form of paychecks.

Partners in private equity firms and hedge fund managers, on the other hand, earn much of their money as a share of their funds’ earnings. And that income gets preferential tax treatment as so-called carried interest.

A similar special tax treatment still holds true for Mr. Buffett as long as the bulk of his income comes from his investments and not a paycheck. The long-term capital gains rate for incomes over $400,000 is 23.8%, including the Medicare surcharge. That’s a far cry from the top marginal tax rate on income above that amount of 40.5%, which includes a 0.9% Medicare surcharge on earned income.

How are people going to react to all of this? Here is advice and observations from some experts in wealth management.

(Hat Tip: Mike Talbert.)

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The whiners at The New York Times can just blame Pres. Obama for signing the tax bill. (Yeah, like that would ever happen.)

Posted by: Woody | Jan 13, 2013 9:31:43 PM

I guess the answer is to create a tax exemption for lawyers. They've suffered enough; why make them pay taxes too?

Posted by: Henry | Jan 14, 2013 7:22:19 AM

keeping with the theory that the more you tax something, the less of it you get from the market, i think we should create an exceptionally high tax rate that applies to lawyers only.

there are too many lawyers and that should discourage more from joining the profession.

No offense Mr. Caron, you are one of the 'good' ones

Posted by: nmh | Jan 14, 2013 10:39:18 AM

For some of that "carried interest" (whatever portion is dividend payments), that actually makes sense (as has been pointed out around here before) - about 50% of company profits designated as dividends are left after the tax man hits it TWICE, so the effective rate is about 50%, not the 20% commonly reported.

And capital gains are also a difficult and complicated area, where taxes have a very difficult-to-predict distorting effect on the market. I make no claim to expertise other than this point - it might be a good idea to increase taxes here or very very bad, but neither argument is going to boil down to a sound-bite... or even an accurate one-page summary.

The main (obvious and hard-to-argue)problem I see is this:

Partners in private equity firms and hedge fund managers, on the other hand, earn much of their money as a share of their funds’ earnings.

For everyone else, something like that would quite simply be a performance bonus, taxed at normal income rates. Unless they have ownership or at the very least full pro/con ownership-like behaviour (they have to pay in if the fund loses money, for instance), then why does it get special treatment?

Posted by: Deoxy | Jan 14, 2013 10:43:27 AM

Just ask John Kerry, and the rest of the Senate millionaires, about the difference between earned (labor) income and investment (capital) income, or in Kerry's case--married-into-it-income.

Posted by: Forbes | Jan 14, 2013 10:54:19 AM

"that income gets preferential tax treatment as so-called carried interest."

There is nothing preferential about the taxation of carried interest. It is the logical result of the way that Subchapter K works. K says first you characterize the income (e.g. ordinary income, dividends, interest, capital gains, etc.) then you allocate it among the partners according to their agreement. If the partnership agreement says the general partners get 20% of all income, that is what they are allocated for tax purposes.

If you think that this result is wrong, you need to tell us how you can fix it without rewriting K. BTW if you rewrite K you must rewrite C and S as well. Personally, I liked Dean Hubbard's comprehensive business income tax proposal.

"A similar special tax treatment still holds true for Mr. Buffett as long as the bulk of his income comes from his investments and not a paycheck. The long-term capital gains ..."

The use of the phrase "special treatment" there is pejorative and misleading. here is nothing special about it at all. There are at least a half a dozen good reason why capital income should be taxed differently than earned income. The income tax laws have always done that, and, absent some fit of good sense like switching from income taxation to consumption taxation, always will.

Of course, the NYTimes is just a bunch of partisan political hacks in journalists clothing.

Posted by: Walter Sobchak | Jan 14, 2013 11:36:57 AM

More to the point, people with hundreds of millions and more need not have any income at all for years at a time. They can surf through periods of high taxes, borrowing against "unrealized" gains for whatever they need, and sort it out when tax rates fall, or leave the problem to their estates.

Posted by: Kevin M | Jan 14, 2013 11:44:27 AM

Nice of the NYT to notice.

The biggest problem in my opinion, though, isn't that NYT readers are paying too much in taxes. It's that they're not paying enough. Let's make it hurt.
Discontinue the Federal deduction for state income tax - want to live in NY, CA, or DC? Gonna cost you.
Discontinue the deduction for mortgage interest - want a big expensive house in Scarsdale/Fairfax/Malibu? Gonna cost you.
Get rid of the tax exemption for nonprofits - work for a university, NGO, or the like? How virtuous of you. Gonna cost you.
An excise tax on movies, music, books might be nice too. We already have the precedent of taxing medical device manufacturers on their gross sales, might as well hit idiot leftist actors, directors, and writers....

Posted by: orthodoc | Jan 14, 2013 12:01:29 PM

The article reflects the problem with how the administration has defined rich based on earnings, rather than true wealth. One this is for sure, tax planners are going to be happy with all the new business to avoid all the new taxes that have kicked in.

Posted by: Andy | Jan 14, 2013 1:11:11 PM

Did anybody seriously think that George Soros would pay any more ?

Posted by: Neo | Jan 14, 2013 1:49:40 PM

Hey Walter:

The interest retained by the manager is distinguished from those issued to the investors in that it is granted in exchange for services, rather than for money invested. When the fund manager receives a profits interest (commonly referred to as a "carried interest"), the partner is not taxed upon receipt, ostensibly due to the difficulty of ascertaining the present value of an interest in future profits. Because it is "difficult" to value the interest, the value of the interest is essentially deemed to be zero at the time it is granted.

My question is, if that is true, why are the fund managers not willing to sell the interest for $10 the next day, or ever give it to someone else (me, for instance)? The answer, as we all know is that the interest is worth many times that amount, and the assigned value of zero is really a fiction.

The profits from this activity clearly are from the effort and services of the people involved. And while these are often very smart and talented people, it seems unseemly for their services and labor to be taxed at levels so much lower than others who presumably labor just as diligently to provide services that are necessary and desirable to their recipients (say, dentists, for example).

Posted by: TaxCynic | Jan 14, 2013 6:35:49 PM