The “carried interest” debate seems to be heating up again and it has me aggravated. Lynn Forester de Rothschild did a piece in the New York Times titled Carried Interest – A Costly And Unjust Perk for Financiers:
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.
Come on Lady Rothschild, stop holding back. Tell us how you really feel.
Cure Is Worse Than The Disease
She goes on to mention that President Obama has called on Congress to close the “carried interest loophole”. This is one of the things that aggravates me about this debate. She does not point us to the proposal. There have been a couple of iterations of Proposed Code Section 710. The problem with them is that they affect more than hedge funds and venture capital and that large hedge funds might figure out how to work around them. More significantly if the tax code instead of being byzantine was just on the verge of being byzantine the 3,000 words of Code Section 710 and the introduction of some new concepts and definitions in partnership taxation might push it over the edge. Partnership taxation is already suffering extensive collateral damage from the war against tax shelters. As Professor Andrea Monroe put it:
Subchapter K today is a diffuse system directed at tax shelters and at the unpredictable activities of sophisticated partnerships. Yet subchapter K’s provisions govern all partnerships, even entities whose commercial activities share nothing in common with the elaborate transactions of sheltering partnerships. In the polarized world of modern partnerships, subchapter K focuses virtually all of its attention on the minority of partnerships at the tax shelter extreme, thereby leaving large numbers of non-sheltering partnerships in a precarious position –wanting to comply with the law, but finding themselves unable to do so without the expenditure of excessive, often cost prohibitive, resources.
If “carried interest” were really just a loophole it would not need such an elaborate fix. In fact, it is based on fundamental principles of partnership taxation.
The Industry Response
The New York Times published a response to Lady Rothschild’s piece about a week later. Steve Judge, President of the Private Equity Growth Capital Council, responded with “Why Carried Interest Is a Capital Gain”. He compares it to two friends, only one of whom has money, partnering to start a restaurant and sharing in the capital gain years later when the restaurant is sold. The restaurant story is actually worked out more elaborately on the PEGCC website, although instead of two friends, it is two sisters.
Overall I think the response is a little disingenuous. It is true that there are a lot of people who build businesses with sweat equity and cash out with capital gains treatment after some liquidity event. For a lot of those people, it is a once in a lifetime event. People who do it year in and year out are in a somewhat different economic situation even if the same tax principles are at work.
Is Obama Really Serious About This ?
I actually am not that disturbed by “carried interest”. If there is going to be a preferential rate for capital gains, people are going to try to structure as much of their income to take the form of capital gain as possible. The only way I have been able to think of to put a serious break on the process is to put some sort of cap on the amount of return on investment that can receive preferential treatment. The theory is that if you are making more than say 25%, you are probably doing something more than just investing. Of course that would mean that people with pure sweat equity would never get capital gains treatment. It is kind of a math geeky type of rule that I could have a lot of fun with. It is also probably not a very good idea. The complexity of the legislative fix to “carried interest” show how hard it is to distinguish between a serial entrepreneur and a venture capital firm that does the same thing in a more structured manner.
If, however, the Administration really thinks venture capitalists and the like should not be getting capital gains treatment, there may be a fix that does not require another three thousand words in the Code and the cooperation of Congress. Just have the IRS rule that operating investment pools as partnerships so that managers can receive their compensation in the form of a share of the partnership’s capital gain is not consistent with the intent of Subchapter K. Those arrangements could be operated as co-ownerships that pay a management company incentive compensation. Make it so. Of course having an option to fix the problem without Congress does not help the administration politically.
That’s the other thing that aggravates me about the debate.
You can follow me on twitter @peterreillycpa.
Originally published on Forbes.com Mar 11, 2013