SHHHHHH…Please Don’t Talk About My Tax Loophole

By The Banker | Blog Posts
15 Nov 2012
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I wrote last week that one of the great lessons of the recent Presidential campaign, for me, is how little we as a country understand income tax policy.

Since we’re about to engage in a crash course in fiscal policy[1] it’s worth focusing on the loophole of carried interest.

Both Presidential candidates referred in the debates to closing income tax loopholes, yet both were deathly afraid of mentioning anything specific, such as the egregious carried interest income tax loophole for hedge funds and private equity funds.  Romney skipped it because his entire Bain Capital career benefitted from it, and Obama skipped it because he’s derived a healthy portion of campaign funding from the same industry.[2]

Industry-specific loopholes like this always prove notoriously difficult to close, because benefits accrue to an intensely interested, knowledgeable, and well funded group, while the general public has minimal to no knowledge of the loophole, no voice at the table, and only earns a very diffuse benefit by closing the loophole.

If you don’t know what carried interest is, then you’re not particularly close to anyone in the hedge fund or private equity world.  Frankly, that is the way we in the investment world would like to keep things.  You – in the dark.  Us – avoiding taxes.

However, as a recovering fund manager dedicated to a fearless moral inventory of all things financial, I’ll explain what you’ve been missing by telling my story.

How I tried, ignorantly, to forgo my right to an awesome loophole

When I set up my private limited investment partnership – also called, inaccurately, a hedge fund[3] – my attorney insisted I set up not one additional Limited Liability Company in Delaware, but rather two.  I tried to resist him, saying I felt most comfortable with just one new business entity.[4]  I was so averse to two new entities that I asked another attorney for a second opinion.  He told me the same thing.  I needed two entities.  I asked my accountant.  His response was, of course, “two entities,” and complete puzzlement at my resistance.  Clearly, they knew something that I didn’t.  That something is the awesomeness of the carried interest loophole.  Needless to say, I got the extra LLC.[5]

Two types of income require two entities

Why did my attorney and accountant insist I create a separate entity?  Because that separate entity can collect payments in the form of ‘incentive allocation,’ also known as ‘carried interest,’ which is taxed advantageously, at the same rate as long-term capital gains[6] rather than as ordinary income.  Here’s how it works.

If you set up a traditional hedge fund[7], first things first: you’ll want to charge the traditional “2/20.”[8] Embedded in this short-hand lingo of “2/20” for hedge fund fees are two types of income.

With the two types of income, you need the two entities to keep the income tracked separately.  Entity #1 collects the “2,” which is taxed like regular business income, and Entity #2 collects the “20,” which collects your totally awesome income at a lower tax rate.

The “2” refers to an annual management fee of 2% of assets under management.  On a small/medium-sized hedge fund of, for example, $500 million under management, you will collect $10 million in management fees per year.  The purpose of this money is to pay for rent, staff, overhead, technology, research – in short all the things you need to do as a fiduciary for the proper care and feeding of the client’s money.  This management fee income will net out with business expenses, and may or may not ever generate “profit” for the manager.  In some fundamental sense, it’s not supposed to generate profit; hedge fund managers are fine earning zero profits from management fees since the $10 million is taxed like ordinary income at 35%, which is, as you know, kinda lame.

The “20” refers to the incentive allocation, meaning specifically that 20% of all annual gains are retained by the manager, in entity #2, as ‘carried interest.’  Here, the hedge fund manager takes full advantage of the loophole.  If the $500 million fund has a gain on investments of 10% this year, fully 20% of the $50 million gain on investments – that is to say $10 million – gets earned by the hedge fund manager’s entity #2 as the ‘incentive allocation’ or ‘carried interest.’

At this point, that ‘carried interest’ gets treated at the rate of capital gains, a 15% tax rate, rather than the 35% taxable rate of ordinary income.  Often, by design, the hedge fund manager leaves the entire 20% incentive allocation inside the fund for it to grow long term.  The manager only owes $1.5 million in taxes (15% of $10 million, at the capital gains tax rate) instead of $3.5 million (35% of $10 million, at the ordinary income tax rate).  As a result of the special tax treatment for ‘carried interest,’ the small/medium hedge fund manager in our example keeps $2 million more than he otherwise would have been entitled to keepThat’s a good deal, for him.

And that’s just one year.

And that’s just for kind of a small hedge fund.

You can imagine the bigger, scale-able results available for when a John Paulson-type fund manager scores  big by shorting the subprime mortgages market in 2007 (probably saved about $740 million in taxes with the loophole) or buying gold in 2010 (probably saved about $980 million in taxes with the loophole)[9]

You can also see why my attorneys and accountant insisted that I set up a separate entity that could take advantage of the tax loophole for carried interest.  My keep-my-life-simple approach made absolutely no sense in the face of potential millions in tax savings year after year.  And they knew that.

Is carried interest deserving of special treatment?

Is there anything special about ‘carried interest’ that justifies the preferred tax treatment?

Proponents argue that because much of ‘carried interest’ stays invested inside of hedge funds, still at a risk of loss, that additional risk justifies the 15% preferred tax rate.

But typically much of that ‘carried interest’ left in the market could be liquidated and taken out by the hedge fund manager anytime.[10]  (You know what else is risky?  Having a job, with a salary, that you could be fired from next week, but you have to pay a much higher tax rate on that salary.  That’s pretty risky too.)

Other proponents of ‘carried interest’ argue that tax policy should incentivize the accumulation of our economy’s scarce investment capital, basically the Ed Conard argument for lower taxes on wealth and investments.

In my opinion, that’s bunk.  Capital is not that scarce for any truly innovative segment of the economy.  Most hedge funds and private equity investments offer little value-added as innovative engines of the economy.  I know that’s my hypothesis, not a provable assertion, but I’ve seen enough on the inside to know – these hedge funds are not the engines of innovation you’re looking for.

At the end of the day, the ‘carried interest’ money is treated better than salary money because it’s been earned by a special class of people – hedge fund and private equity fund managers – who are much more influential in the political process than the average worker.  Full stop.

All of this is why I wrote last week that I would appreciate it if both sides of the political aisle would just stop lying to us about fiscal policy and loopholes and treat us like adults.  I’m ready to be pleasantly surprised.  But I’m not going to turn blue holding my breath.



[1] Thanks to the overheated discussion of a completely politically synthetically created crisis known as the Fiscal Cliff.

[2] Don’t be overly misled by some of the anti-Obama rhetoric from titans of the hedge fund industry like Omega’s Leon Cooperman.  Despite Cooperman’s choice comparisons to Nazism, or Dan Loeb saying Obama’s treats them like ‘battered wives,’ hedge fund and private equity managers know that Obama’s been all talk and no action when it comes to what they really care about.  Which is the carried interest loophole.

[3] A pet peeve of mine as well as for many people in the industry, the use of the term ‘hedge fund’ to describe what is better described as a ‘private investment limited partnership.’  ‘Hedge fund’ implies something that has no relation to my business.  I did no hedging.

[4] My reason at the time was that as a small business, I wanted to keep things simple.  A new entity meant the additional cost of entity creation and maintenance, a separate set of accounting books, a separate set of tax returns, etc.  Boy was I wrong about the potential costs and benefits, as I’ll explain below.

[5] Here’s a handy rule of thumb for non-financial people:  Whenever you see a company or business situation with lots and lots of separate business entities, you can be confident there’s tax avoidance going on.  It’s possible there’s also an attempt to shield the principals from bankruptcy, but it’s either that, or tax avoidance.  Anyway, just an FYI.

[6] See my earlier posting on tax rates for different types of income.

[7] Or private equity fund, but for the purposes of this illustration I’ll just refer to a ‘hedge fund.’

[8] Industry folks, bear with me, as you already know this, but the non-financial types don’t:  Insiders refer to hedge funds not as an asset class but as a compensation scheme.  The “2/20” is why.

[9] I’m assuming his reported gains of $3.7Billion and $4.9 Billion respectively, the largest portion of which would be in the form of tax-advantaged incentive allocation.

[10] Admitedly less so for a private equity manager, whose investments tend to be less liquid.

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10 Comments

  1. Chris Whyte says:

    “Whenever you see a company or business situation with lots and lots of separate business entities, you can be confident there’s tax avoidance going on. It’s possible there’s also an attempt to shield the principals from bankruptcy, but it’s either that, or tax avoidance.”

    I believe this points to a fundamental problem with capital gains taxation. This emphasis on tax avoidance drains capital away from more productive investments.

    In addition, there’s no correlation between cap gain rates and VC investment or economic growth (i.e., changes in real GDP). However, there’s a high correlation between corp and individual cap gains (as a % of GDP). This correlation is interesting since they changed at different times. For example, individual rates were lowered in ’81, ’97 and ’03 but the correlation between the two was largely unaffected.

    Lastly, 70% of all realized cap gains are now concentrated within the top 1%. Question: How can investment be growing when the gains are concentrated amongst such a small percentage of the population?

    This whole idea that low cap gains rates promotes investment seems intuitive on the surface but is full of holes once you dig into the details. All of the evidence says that cap gains realizations grows and shrinks based on business cycles and not tax policy. It appears the belief that increasing cap gains rates reduces revenues is based on a highly selective reading of the facts.

    • The Banker says:

      I think the assumption that a majority of savings on capital gains becomes productive capital available for innovation and economic growth hinges on the idea that capital for innovative ideas is very scarce. In that scenario, it makes sense to me that restricting capital is, in a sense, restricting innovation and growth. I think that’s the Conard argument in a nutshell.
      The contrary view would say that capital available for innovation, at least for our economy and in our country and in our present times, is quite easily come by. Restricting some capital (e.g. through additional capital gains taxation) in the contrary view might have less of a negative effect on innovation and growth.
      To your ‘Lastly’ point…I think the concentration of capital gains among the top 1% doesn’t make it less relevant for innovation and growth.

      • Chris Whyte says:

        Interesting…

        I guess I’m struggling with how anyone can view capital available for innovation as being scarce. It might help if someone gave me example of when it was plentiful or what plentiful might look like. Is it possibly scarce (in Conard’s mind) because so much capital is being allocated for purposes of tax avoidance and not innovation (that wasn’t sarcasm)?

        Note: I realize that at least some capital allocated for the purposes of tax avoidance can also be used for innovation but I have a hard time believing that’s a significant goal for anyone focused on avoiding taxes.

        Also, regarding the concentration, sorry, I didn’t mean to imply that it makes it less relevant but is this a trend that we want to continue to see? Without a doubt, the concentration amongst the 1% is only growing. To me, it seems equivalent to putting 70+% (and growing) of my money on an asset that represents 1% of my investments. It works but it isn’t very scalable to depend on so few to fund innovation and growth in this country. It also implies that the 1% will always be focused on allocating capital for innovation and growth as opposed to doing selfish things. For example: Will some of them spend more time funding projects that are important to them as opposed to a majority of the US? Not sure about you but I’m not comfortable making that assumption. Also, is this not an obvious factor contributing to inequality?

        Btw, thanks for the dialogue!!

  2. richard adams says:

    These posts are very interesting to me although not being a “numbers” guy really creates a lot of road blocks in ones comprehension. You definitely consider me as part of the “in the dark” group. I am a self employed person who wants to know the real geography of the economy we live in as it is in my own and my families interest to know. I appreciate your effort to inform us as part of your own health and well being as it is one of the few real life giving rewards that we are able to gain. Helping others is the highest calling we have and your efforts in this are greatly valued. I will have need to ask many questions and will require clarifications in order for me to comprehend these realities. Have a wonderful holiday season!

    • The Banker says:

      Great, please ask questions. If you’ve got them then so do many people. I hope the dialogue can help us all understand a bit better.

  3. richard adams says:

    Question: I am a full time land lord. The rental properties I own were purchased in 1031 exchange as the result of the sale of a rental home in California. I seem to recall our tax accountant mention something about carried interest deduction in a discussion of our tax return. I am vague about this though. Is this “carried interest” deduction just a deduction for financial service companies or does it have a broader scope?

  4. Sweet Honey says:

    I’m not for wealth distribution, but this loop-hole needs to close. I’m in a high tax bracket and get a straight w2. Are they going to close this loop-hole or are only my taxes going up?

    • The Banker says:

      Ultimately it depends on whether your representatives value private equity and hedge fund manager’s contribution to society more than your contribution to society. If I had to place a bet I’d say they value private equity and hedge fund managers more. They don’t literally say that, but that’s the way they write tax policy.

  5. Offshore passive foreign investment companies (called PFICs and QEFs by IRS) don’t have to file income tax returns. See the attraction?

    http://tomazz1.wordpress.com/2014/03/08/tax-planning-for-pfics-and-cfcs-and-fatca/

    Bain Capital ($70 B AUM) have 138 PFIC funds in the Cayman Islands to avoid Capital Gains taxes.
    Mitt Romney filed form 8621 for 10 QEFs in 2010.

    Visit us on twitter
    https://twitter.com/TaxHavens

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