I sometimes think that I am the only person who writes about taxes in a non-technical publication, really understands what “carried interest” is all about and does not find it particularly upsetting. So I was particularly annoyed when I saw that the Green Party Platform was condemning carried interest, The proposal is to end “corporate welfare” by inter alia eliminating:
the tax loophole for “carried interest” from private equity and hedge fund managers
What is “carried interest”?
Carried interest is not a “loophole” in the classic sense. It is based on fundamental principles of partnership taxation. Carried interest is not a technical tax term. It is more of an industry term. The tax term is “profits interest”. The idea of a profits interest is that when you are admitted to or form a partnership and all you have is an interest in future profits you have no immediate taxable income. The other thing that makes the benefit work for private equity managers and a host of other people who are treated as partners without necessarily having invested anything is the idea that a partnership is a “taxpayer”, even though it does not pay taxes. What being a taxpayer means is that it has its own method of accounting and that the determination of the nature of income is made at the partnership level and flows through to the partners.
If Mr. Big Bucks hires Boy Genius to pick investments for him and pays him a fee based on performance, Mr. Big Bucks has a capital gain and a deductible fee (of dubious value because of thresholds and AMT) when stocks are sold, while Boy Genius has ordinary income. If instead they form a partnership which Mr. Big Bucks contributes money to and in which Boy Genius receives a profits interest, then it will be the partnership that has a capital gain, which it flows through to its partners. There is no fee necessary. (Venture capitalists might get both a fee and a profits interest, but this is meant to be a simple example).
Should We Blame Romney For This ?
Absolutely not. Romney gets flack about this because he has taken advantage of it. My thought on that harks back to the words of Learned Hand:
Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so,rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.
If Romney is elected and rolls out a detailed tax plan that leaves this perceived abuse intact, then maybe you can start blaming him for it.
Should We Blame Obama For This ?
Maybe. Of course I don’t blame anybody, since it does not upset me. There has been legislation introduced to fix the perceived abuse. The legislation proves that carried interest is not a loophole. Proposed Code Section 710 in one of its forms adds three thousand words to the Internal Revenue Code and introduces entirely new concepts. It would apply to more people than investment managers and, itself, has loopholes that some investment managers could slip through. Of course, Obama knew it would not pass, but it lets him look like he is trying.
Some experts do think carried interest is a loophole rather than something based on fundamental principles. If they are right, it could be fixed with a paragraph in the regulations. Basically IRS would say that the arrangement between Mr. Big Bucks and Boy Genius is not in substance a partnership. Maybe the courts would go along with it and maybe they wouldn’t. The Obama administration has not tried that. I think they have not tried it because it actually might work and Obama also gets money from private equity.
Why Does The Green Party Care ?
That’s what really annoys me. I think the Green Party cares because the people who wrote the platform don’t know what “carried interest” is. To them it is just an example of the bad things that the 1% does and keeps showing up on Obama’s list of “usual suspects” when tax reform is discussed. The Green Party does not believe that there should be a preferential rate for capital gains. If that were the case then it would make no difference to Boy Genius as to whether he had capital gains or ordinary income. Here is my discussion with Doctor Stein on that
I have not yet received the formal invitation to be part of the Green Party’s Tax Think Tank. I haven’t received copies of Doctor Stein’s returns or a picture of Bandita, the Green Party candidate for First Dog, either. It is just as well. It is a busy time at the day job and I still have a few more posts from the interview to do. Here is a link to the whole interview if you have an hour to kill.
You can follow me on twitter @peterreillycpa.
Originally published on Forbes.com Oct 11th, 2012