Carried Interest !

[frayne]

Really feel kind of stupid that I had never heard of this before the past Sunday presidential debate. After googling and gaining some understanding of the concept/tax loophole I am simply amazed at how the tax code favors those in the upper brackets.

 

[The Rodent]

Knowledge is power and power usually translates to money.

I don't view it as a tax "loophole". It was designed that way by very knowledgeable people to benefit special interests. Why do you think it hasn't been changed?

 

[jazz4cash]

Well you are not alone as almost no one I know understands basics of Federal Income Tax. Marginal rate? Effective rate? Deduction vs Credit? Give me a break! All anybody knows is if they got a refund or had to pay (more).


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[pb4uski]

Yeah... I've never been a fan of the tax preferences for carried interest. In substance it is a management fee and should be ordinary income IMO. Investors are risking capital but managers don't.... worst case they don't get paid if the investment goes south so they share some pain with investors, but not much.

 

[audreyh1]

How can I arrange things so that I can get a management fee for managing my own investments?

 

[travelover]

......I am simply amazed at how the tax code favors those in the upper brackets.

Pure coincidence.

 

[ChiliPepr]

How can I arrange things so that I can get a management fee for managing my own investments?

The management fee is in addition to carried interest and is usually used to pay the expenses of the fund, research, Bloomberg, salaries of support staff, rent, etc.

 

[frayne]

Well you are not alone as almost no one I know understands basics of Federal Income Tax. Marginal rate? Effective rate? Deduction vs Credit? Give me a break! All anybody knows is if they got a refund or had to pay (more).



Sent from my iPhone using Early Retirement Forum

I have done personal and small business taxes for seven years, probably over 2000+ returns and still was not aware of the carried interest tax advantage.

 

[ChiliPepr]

I have done personal and small business taxes for seven years, probably over 2000+ returns and still was not aware of the carried interest tax advantage.

You would not even know if someone you did taxes for received "carried interest" in compensation. I receive carried interest as a portion of my comp and it just shows up as a K-1. So anyone who had a K-1 could of had carried interest.


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[ERD50]

Really feel kind of stupid that I had never heard of this before the past Sunday presidential debate. After googling and gaining some understanding of the concept/tax loophole I am simply amazed at how the tax code favors those in the upper brackets.

Wait a minute - isn't that a contradictory statement? If the tax code favored them, they would not be in the upper brackets! The upper brackets is a 'penalty' of sorts (side note - for the record, I'm in favor of a progressive tax rate).

OK, so I don't know much about carried interest, though I do know about many of the things mentioned (marginal versus effective tax rate, deduction versus credit, plus cap gains rates, loss carry forward, etc), and I do think that many/most people have no clue on those topics.

But a quick search shows:

What is carried interest, and how should it be taxed? | Tax Policy Center

Carried interest is a contractual right that entitles the general partner of a private investment fund (often a private equity fund) to share in the fund’s profits (figure 1). A fund typically uses the carried interest to pass through its net capital gains to the general partner which, in turn, passes the gains on to the investment managers. The managers pay a federal personal income tax on these gains at a rate of 23.8 percent (20 percent tax on net capital gains plus 3.8 percent investment tax).

If I read that right, it is cap gains flowing through as cap gains. So what's wrong with them being taxed at cap gains rate? It sounds a lot like the cap gains distribution many of us get from a mutual fund. Are we, mere mortals, being 'favored'?


BTW, another 'advantage' often sited is the 'preferential' treatment of long term (>1 year) cap gains (lower than earned income). However, we had a discussion on that a few years back, and demonstrated how sometimes the cap gain rate is actually a penalty. Short story, if you had a long term cap gain of say, 10%, but you bought the investment 20 years ao, you actually lost out to inflation. It's not the same at all as a 10% gain that is 1 year and one day old, but it is taxed the same. You should be able to factor in an inflation adjustment, and take it as a loss against other gains (or carry it forward against future gains, as our tax laws permit, and is only sensical under these rules).

-ERD50

 

[ChiliPepr]

That is all true, but it is not always at the long term rate...

If you were the general partner of a fund and at the end of the year it had a a 100k in gains, 20k in long term, 30k in short term and 50k in unrealized, and this all went to the one partner, their k-1 would show 4K in long term gains and 6k in short term gains. Their account balance would include the 10k in unrealized gains, which would not have any taxes taken out of it until the asset is sold.

 

[pb4uski]

....But a quick search shows:

What is carried interest, and how should it be taxed? | Tax Policy Center



If I read that right, it is cap gains flowing through as cap gains. So what's wrong with them being taxed at cap gains rate? ...

I'm not sure if you are reading/interpreting it right. What it is is a sharing of gains as compensation to the manager of the fund for managing the fund. However, the manager does not share in losses (other than not being compensated for managing the fund) and has no capital/principal at risk (though their time and effort is potentially at risk).

As I understand it, part of the reason that we give tax preference to long-term capital gains is to incentivize investors to provide capital (that in turn is invested in businesses that create jobs, etc.) The recipients of carried interest do not supply capital... then manage investments of capital supplied by the investors.

In its simplest form, it is the investors agreeing to share gains for fund management rather than pay a straight % of AUM. From the manager perspective, it is variable compensation... managing for a percentage of the gains with some upside if the investments do well and some downside if they do poorly.. but still essentially compensation for providing a service.

As an example, investors invest $100m and agree to share 20% of gains. The investment does well and realizes $20m in long-term gains... $4m is paid to the manager and $16 million reverts to the investors. Not much different than a management fee on a mutual fund except to fees are variable (a % of gains) rather than a % of AUM.

 

[ERD50]

I'm not sure if you are reading/interpreting it right. What it is is a sharing of gains as compensation to the manager of the fund for managing the fund. However, the manager does not share in losses (other than not being compensated for managing the fund) and has no capital/principal at risk (though their time and effort is potentially at risk). ....

OK, thanks, that makes it clearer. It is kind of a hybrid I guess. No capital at risk, no losses, but a 'risk' of no payment. And, one could argue, (maybe not convincingly) that it 'deserves' a better rate as it is helping to grow the economy through investment.

It seems pretty easy to argue either side, I don't think it is cut and dried.

And I guess (not to digress too far), that's why I wish we didn't have an 'income' tax - I think 'income' is too hard to define. Not that it will ever happen, but I think a national sales tax would work better. It is easy to define what you spend, just like we collect state sales tax in most states. Yes, there are some complications to that too, but far fewer than Income Tax I think. And no claims that some rich guy didn't pay any taxes (unless he didn't buy anything that year).

-ERD50

 

[pb4uski]

....I think 'income' is too hard to define. ...

In this case the "income" is easy to define, the difficult part is determining whether it should be ordinary or preferenced ... however most other forms of variable compensation that I can think of tend to be ordinary income (like performance bonuses, etc.).

In a way it is sort of like a law firm taking a case on contingency... poor outcome results in wasted time and effort... great outcome results in a windfall... and it is ordinary income for the law firm so I don't see why a hedge fund should get preferential treatment... it is the same risk and actually less of a binary risk than the contingency example since the hedge fund has a wide range of possible outcomes.

 

[MooreBonds]

OK, thanks, that makes it clearer. It is kind of a hybrid I guess. No capital at risk, no losses, but a 'risk' of no payment. And, one could argue, (maybe not convincingly) that it 'deserves' a better rate as it is helping to grow the economy through investment.

It seems pretty easy to argue either side, I don't think it is cut and dried.

And I guess (not to digress too far), that's why I wish we didn't have an 'income' tax - I think 'income' is too hard to define. Not that it will ever happen, but I think a national sales tax would work better. It is easy to define what you spend, just like we collect state sales tax in most states. Yes, there are some complications to that too, but far fewer than Income Tax I think. And no claims that some rich guy didn't pay any taxes (unless he didn't buy anything that year).

-ERD50

I don't have a thorough understanding of the "carried interest" provision...but my understanding is that one (the main?) beef is also that the vast majority (perhaps all?) of the carried interest "gain" is their compensation. It's not like they have a W2 salary of $1MM or $3MM that is taxed at ordinary income rates and their bonus is some capital gains. I believe that their entire (or essentially all) of their compensation is in the form of capital gains....effectively bypassing various Federal/SS/Medicare taxes?

Also (again, I don't know if this is true, or just an issue unrelated to the Carried Interest provision of the tax code), but part of the issue with private equity investors like the bru-haha over people like Mitt Romney is that they are able to include ROTH IRA purchases of thousands of shares of their various private-market acquisitions at essentially fractions of a penny....then, when the investment pays out, their ROTH IRAs are worth millions. Yes, they have a risk that the investment may go bankrupt or may not rise much, but I'm willing to bet that there aren't many private equity investors who have IRA balances in just the 4 or 5 digit ranges.

 

[Alan]

I'm amazed that so many folks here haven't heard of carried interest since there was a lot of discussion on it during an earlier election when tax returns were published.

 

[ChiliPepr]

I don't have a thorough understanding of the "carried interest" provision...but my understanding is that one (the main?) beef is also that the vast majority (perhaps all?) of the carried interest "gain" is their compensation. It's not like they have a W2 salary of $1MM or $3MM that is taxed at ordinary income rates and their bonus is some capital gains. I believe that their entire (or essentially all) of their compensation is in the form of capital gains....effectively bypassing various Federal/SS/Medicare taxes?

Yes, this is a definite possiblity, the issue with doing something like that is if the fund is down for the year, you do not get any of the carried interest so your compensation for that year would only be your small salary (probably not a big deal for some of these people)

Also, if you are down in one year, you have to make up the loss in the following years before you collect on any carried interest. For example, if the fund start out new with a million dollars, and the first year it is down 25% to $750k, no CI is earned, if the next year it goes back to one million dollars, no CI is earned, if the next year it goes to $1.1 million, 200k of the 100k is earned as CI.

Also, management fees are included in earnings of the fund, so if you paid a 1% management fee and all the other investments were flat, the fund would be down 1% and would need to be made back before any CI would be earned.

 

[Totoro]

There was alot of hoopla with Romney about it, it's one of the ways he managed to get a very high IRA balance.

Anyway, trying to simplify here. I manage your money, you pay me a portion of the gains when I do that successfully.

Now, depending on the way you pay me I either pay alot of taxes, or less than my secretary (relatively speaking). The first route is if I get the payment through income. The second route is declaring the payment as capital gains (on the investment of other people's money).

Since the second route is lower tax, investment managers, hedge funds etc .. obviously choose that one.

Most people would argue (me included) that logically, it should be income. If it's your own money, it gets more complicated. If you work hard at allocating capital (your own), and it pays off, should it be taxed as income? It's your job after all.

Answers aren't easy, since with investment management one can have 'negative income'. Mind you, also in hedge funds claw-back provisions exist.

 

[pb4uski]

....Most people would argue (me included) that logically, it should be income. If it's your own money, it gets more complicated. If you work hard at allocating capital (your own), and it pays off, should it be taxed as income? It's your job after all.

Answers aren't easy, since with investment management one can have 'negative income'. Mind you, also in hedge funds claw-back provisions exist.

Agree.. and if carried interest were eliminated what hedge fund managers may well do is to concoct a scheme to put some minimal amount of capital at risk to convert the income to capital gains income to continue to get preferential rates... in which case there would need to be some mechanism to bifurcate income between ordinary and capital gains.

The negative income as a result of a clawback would only be in a year or years... but inception to date income could not be negative since a clawback would only recapture previously paid income.

I guess at the end of the day I would like to see alignment between the taxation of performance bonuses, contingency fees, carried interest, etc. As stands, it seems to me that carried interest gets an unfair advantage. I guess if you have substantial principal at risk of loss then some preference would be appropriate if they want to encourage investment of capital.

 

[ponyboy]

No matter who wins in november carried interest is not going away. I can guarantee that.

I never heard of it either but after reading what it is...yeah its staying put.

 

[Closet_Gamer]

I was near one of these legal/compensation structures many years ago. It didn't work out, so I never reaped $1 of gross benefit from it, nevermind any tax benefits.

That said, I spent the first several weeks asking "is this legal?" The management participants have zero or negligible capital at risk yet due to the legal structure receive capital gains treatment. I suppose one could argue that their "investment" is just receiving outsized returns but that is a mighty thin fig leaf. They can go further and have the fund management company issue a non-recourse loan to the management employees to "invest" in the fund, but it's all just so much left-pocket/right-pocket nonsense. The managers real world risk remains quite modest.

For all practical purposes, the managers share in the "upside" of investments but have negligible exposure to the downside. That makes it income and not the result of at-risk gains in my book. At the very least, any gains beyond the managers pro-rata share of the capital invested (and therefore the capital gains achieved) should be taxed as ordinary income. If my megacorp came up with a structure whereby I put $1 in a fund that invested solely in megacorp stock while they put in $100 and then we split the upside 20/80 the IRS would call the resulting gains ordinary income in a heartbeat.

We have strong rules elsewhere in the code that link treatment to risk. For example a non-qualified deferred comp program allows large deferrals because the assets must remain at risk of a company bankruptcy whereas a 401k is more limited in scope but is also moved beyond the reach of company creditors.

IMHO, the carried interest exemption should be eliminated.

 

[exnavynuke]

If the carried interest is the only compensation for "doing their job", then I think there is a fair argument that they've risked their entire salary on the investment and thus carried interest kinda makes sense. If it's treated as a "bonus" for doing well (i.e. they get paid XYZ but then also get the carried interest if they perform well in their job of making the investment show gains), then I think it should be taxed like any other bonus.

 

[Danmar]

Canadian tax code doesn't provide such benefits. Not sure about other OECD countries, but I doubt they do either. What's that old song? " Only in America, Land of Opportunity".

 

[Fermion]

Most stock options given to ordinary employees are similar to the carried interest thing, except they are taxed at ordinary income.

A) You put very little if any money in

B) You don't lose if the company and options perform poorly

C) You gain if the company and options/stock do well

I wonder why stock option grant gains are not taxed like carried interest, at a cap gains rate?

 

[Danmar]

Most stock options given to ordinary employees are similar to the carried interest thing, except they are taxed at ordinary income.

A) You put very little if any money in

B) You don't lose if the company and options perform poorly

C) You gain if the company and options/stock do well

I wonder why stock option grant gains are not taxed like carried interest, at a cap gains rate?

Actually, this is a good point. In Canada employee option gains are taxed at the same low rate as cap gains. However, in recent elections and budgets there has been a lot of discussion of eliminating this benefit. I would guess it will soon be gone.