Paul L. Caron

Monday, February 25, 2013

Rothschild: It is Time to End the Carried Interest Loophole

New York Times op-ed:  A Costly and Unjust Perk for Financiers, by Lynn Forester de Rothschild (CEO, E. L. Rothschild):

Of the many injustices that permeate America’s byzantine tax code, few are as outrageous as the tax rate on “carried interest” — the profits made by private equity and hedge fund managers, as well as venture capitalists and partners in real estate investment trusts. This huge tax benefit enriches an already privileged sliver of financiers and violates basic standards of fairness and common sense.

President Obama recently suggested that he would ask Congress to close this loophole. Eliminating the carried-interest tax rate should be an easy sell. It should play to Republicans’ supposed hatred of government handouts and to Democrats’ commitment to social justice.

But because of the financial lobby’s clout, the loophole most likely won’t be closed. If it isn’t, shame on both parties for giving us another reason to distrust our democracy and our capitalist system.

While the tax legislation passed on Jan. 1 increased the top individual-income tax rate to 39.6% from 35% for couples making more than $450,000 and individuals making more than $400,000, it left carried-interest income taxed at just 20% ...

No other affluent Americans enjoy this benefit. A brain surgeon, stockbroker, corporate lawyer or actor will have to pay the new top marginal rate percent, while a general partner who manages other people’s money pays, on carried-interest income, only the 20% rate on long-term capital gains. ...

This state of affairs denies our Treasury much-needed revenue; fuels public cynicism in government; and is evidence of the “crony capitalism” that favors some economic sectors over others. When plutocrats join with both parties to protect their own vested interests, the result is a corrosion of confidence in the free-market system.

The carried-interest loophole may seem small compared with this year’s projected $900 billion deficit, but ending it would be a major signal that Washington is ready to put an end to business as usual.

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Far be it from me to criticize a Rothschild, but isn't it a bit misleading to characterize carried interest income as though it were a salary for "manag[ing] other people’s money"? After all, if a brain surgeon does the surgery, he gets paid. If a corporate lawyer (like myself) bills the hours, he gets paid (hopefully). If a PE fund doesn't make profits, typically in excess of a specified rate of return to the LPs, then the GP doesn't get anything--no matter how hard the GP's employees worked at "manag[ing] other people's money." (I acknowledge, of course, that most fund sponsors also charge management fees to cover their overhead.) In other words, there's investment risk associated with the carried interest, which, as I understand it, is one of the chief justifications for having a lower capital gains rate.

Posted by: Mike | Feb 25, 2013 12:53:39 PM

With all due respect, the NYT is absolutely wrong on the carried interest matter. An example should prove helpful. Let's say the evil wall street guy puts up $10 and the large private investor puts up $90 of equity. They agree between themselves that the profits will be split 90/10 until the private investor makes a certain percentage return on its investment, usually defined as some target internal rate of return (IRR). Once that IRR target is hit, they agree to split the profits 70/30, for example. Because of the way IRR is calculated, it is very difficult to achieve the targeted returns until an exit event occurs, such as a sale of the underlying investment. IF the IRR target is hit before a sale, the ordinary income would be spit 70/30, and the wall street guy's share of that would be taxed at ordinary income rates. In the more likely event the IRR target is achieved in connection with a sale of the asset held for more than 1 year, the long term capital gain would be split 70/30. Let's put some numbers to that. Let's assume that the total long term capital gain earned by the ownership entity was $1,000. All of that income is capital gain. Under existing law, the two partners together have capital gains of $1,000, but they agreed to split it other than pro rata to their capital contributions. Where is the tax break here? Under the proposed carried interest rules, the $300 of gain allocated to Wall Street would be treated as ordinary income as compensation for services rendered. If this is the case, then the investor should have $1,000 of capital gains, but it should now also have $300 of deductions for compensation paid to Wall /Street. What have we gained?

Posted by: Greg | Feb 25, 2013 4:24:59 PM

Apologies to Mike above, but the brain surgeon and corporate lawyer examples (an intriguing comparison, but one best considered another time) actually contradict the notion that a carried interest has investment risk that entitles the holder to favorable capital gains tax rates.

Posted by: Jake | Feb 25, 2013 5:13:54 PM