Taxes Rant: Carried Interest Edition

Note: A version of this post appeared in the San Antonio Express News.

Dear Money: I miss you so, so much.

I recently mailed off – with deep feelings of loss – two of my biggest checks of the year: one for real estate taxes to the county where I live and the other to the IRS for estimated federal income taxes.

Money: I miss you so, so much
Money: I miss you so, so much

After we said our long sorrowful goodbyes at the US Post Office, money and me, I wiped those tears away, threw my shoulders back, and bravely walked back to my car. No looking back. Please, county and federal government, take good care of my money. I raised it with my own two hands, and I dearly loved it.

Don’t worry, though, this is not going to be an anti-tax rant. I’m not a TEA Party member. [1]

On the contrary, over the years I learned to embrace what my accountant taught me: If you think you pay a lot in taxes, try to remember to be happy, because it means you made what to you is a lot of money that year. Or, in the case of real estate taxes, paying a lot means you own valuable real estate.

Seen that way, complaining about paying high taxes is unattractive in the same way that a guy bemoaning the cost of expensive repairs on his Porsche is unattractive. I mean, seriously, don’t be that guy.

The key is fairness

While I believe everyone should pay a fair share of taxes, the key word here is fair.[2]

Since I just coughed up too much money in federal income taxes and local real estate taxes, I’d like to complain now about an unfair aspect of federal income taxes. Later, in an upcoming post, I’ll rant about unfairness in local real estate taxes.

Federal Income Tax unfairness

I started and ran a hedge fund for a short while. (This was years before I landed this lucrative gig writing financial rants online, for free. But anyway.)

The awesome thing about running a hedge fund or private equity fund is just how unfairly advantaged these business structures are, from a federal income tax perspective.

Fund managers earn fees in two ways, a ‘management’ fee and a ‘performance’ fee, sometimes also known as ‘carried interest.’

The more important of these – the ‘carried interest’ or ‘performance’ fee – in most cases gets taxed at a lower rate than other types of income because of the illusion that the performance fee is somehow like ‘long-term capital gains,’ rather than like regular income. It’s not.
But the tax law says it is, so, big tax advantages if you’re a hedge fund manager!

Carried interest tax loophole
Carried interest tax loophole

If we were talking about the regular scale of incomes for a blue-collar or white-collar job of people you meet in your ordinary life, the difference in these tax rates might not matter much, something on the order of $500, up to maybe $5,000, tops.

But since we’re talking about hedge fund manager-level earnings – which sometimes hit a billion dollars a year, the difference in the tax code for certain individuals can reach the hundreds of millions of dollars per year level. Which, I don’t know, starts to chafe me in my sensitive areas a bit.

Don’t get me wrong, we can all agree that nobody deserves an unfair tax break more than private equity and hedge fund owners, but at a certain point we begin to wonder about the extent of the unfairness of it all, no?

 

Please see related posts on taxes:

Shhh…Please don’t talk about my tax loophole

Adult conversation about tax policy

529 Accounts and tax fairness

 

[1] A quick aside to my liberal friends who think the TEA Party is something new. Unhappiness about paying taxes (TEA, as we know, stands for Taxed Enough Already) is as American as Apple Pie, the Star Spangled Banner, and eating greasy food until you nearly burst, on Super Bowl Sunday.

The drunken faux-Indians of the Boston Tea Party Patriots hated paying taxes to the English King. The death-seeking gun-nuts of the Alamo hated paying taxes to Mexico City, and the tyrant Santa Anna. A complete history of the United States could be written using tax-opposition as the prime motive for all major events. I’m not saying TEA party folks aren’t wacky (because many are!) but I am saying at least they have a long list of historical precedents from which to draw political sustenance.

[2] A quick aside on fairness: Fairness, of course, is in the eyes of the beholder.
In my family we retell the story of my super-cute niece, then aged four, who announced one evening: “It would be fair, to me, if I got to take a bubble bath after dinner.” She had learned enough by age four that “being fair” was important to adults, but like many of us, decided to interpret fair according to her own worldview. Since then, I frequently tell my family over dinner that it would be fair, to me, if someone drove out to Dairy Queen and bought me a treat, like, right now. This never works. Anyway, fairness. It’s important in the tax code.

[3] In the tax world, there are always exceptions to everything so I am simplifying greatly and using these hedging words like ‘usually’ and ‘sometimes’ and ‘often.’

 

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Sheldon Adelson Should Bet Even More on the GOP

Two things you can count on with a casino entrepreneur like Sheldon Adelson: he knows the odds better than you do, and the house always wins.

In a recent Wall Street Journal interview, Sands Casino owner Adelson shares his left-of-center political beliefs, including support for abortion rights and stem-cell research, the DREAM act, and socialized medicine.  So why would he pour a reported $150 million[1] in 2012 into losing Republican candidates in the last election?  And why would he vow to double that amount in the next go around?

The answer clearly lies in his odds-based analysis of tax policy, and his views of expected value.

I’m going to assume some simple numbers for Adelson’s net worth and annual income, and go through a quick analysis of the kind of odds Adelson works with in his head that leads him to be so generous to GOP candidates.

Let’s assume Forbes Magazine’s estimated $20 Billion net worth for Adelson, and my estimate of $2 Billion for Adelson in annual income.[2]  To begin by stating the obvious, when you make $2 Billion a year[3], tax policy matters quite a bit.

Throughout the Presidential election, I’m going to assume Adelson knew the odds of a Romney victory were always around 40%.[4]  I’m going to further assume a 25% chance that a Republican Presidential victory can lead to lower taxes.[5]

These seem like reasonable assumptions about the odds of influencing different tax rates, but of course you’re free to disagree and propose your own.[6]

Ordinary Income Tax

Adelson pays himself $1 to 2 million a year to run his Sands Casino empire. [7]

If I assume a GOP victory influences the highest marginal income tax rate by 5%, the expected value to Adelson of a GOP victory becomes his highest marginal income (I’m going to use $1,000,000 for easy math again) multiplied by the change in tax rate, multiplied by the odds of a GOP victory, multiplied by the odds of successfully influencing the tax rate.  In other words:

$1,000,000 x 5% x 40% x 25% = $5,000

So…When Obama talks about raising income taxes on people earning more than $250,000 a year, Adelson really couldn’t give a flying whoop about the marginal tax rate on ordinary income.  You might care, but believe me, Adelson doesn’t care.  Retaining an extra $5,000 a year is not why Adelson gives to the GOP.

Dividend Tax

The qualified dividends tax rate currently stands at 15%, but will jump to 39.6% without a new provision to favor this type of income by January 2013.  As I wrote earlier, wealthy folks care more about dividends and capital gains taxes than taxes on salaries.  A GOP victory could have as much as a 20% effect on the marginal tax rate.

To avoid that, and in a move that should be surprising to precisely nobody, Adelson just announced a special dividend of $2.75 per share to be paid on December 18, 2012.  With 431.5 million shares of Sands, Adelson will be sending himself a nice $1,186,625,000 holiday present.[8]  This dividend supplements the typical 25 cents per share per quarter that Sands pays, or $431,500,000 per year that Adelson earns in ordinary dividends even before this special dividend.

If Adelson plans to make himself an estimated $1,500,000,000 qualified dividend payment annually, his expected value of a GOP victory is:

 $1,500,000,000 x 20% x 40% x 25% = $30,000,000

Now that is something worth trying to influence through political donations.  Heck, he could have made his money back in 6 months if Newt Gingrich had gone all the way to the White House.

 

Long Term Capital Gains Tax

Adelson, like the rest of us, pays 15% on his long term capital gains, from harvesting gains in securities that appreciate in value.  With no deal before January 2013, that rate jumps to 20%, still comfortably better than the kind of suckers-rate of 35% that high salary earners pay for working for a living.[9]

I assume Adelson’s got about $100,000,000 in long term securities gains he can harvest, and a GOP victory could influence that rate by 5%, leading to an expected value of:

$100,000,000 x 5% x 40% x 25% = $1,000,000

Corporate Tax

Corporations the size of Sands Casino pay a 35% rate on corporate profits.  For a number of non-crazy reasons either a Democratic or Republican tax regime might lower this, but let’s assume the GOP’s ability to lower this top rate by 5%.  Just for kicks, to reflect the fact that corporations can greatly influence the amount of ‘profit’ they declare domestically in any given year, and to come up with round numbers, I’m going to assume a scenario in which Adelson’s proportionate share of Sands’ corporate profit is $399,000,000 annually.[10]  His potential tax savings from a GOP victory therefore are:

$399,000,000 x 5% x 40% x 25% = $1,995,000.

Corporate profits may be voluntarily reduced or heavily managed through off-shoring earnings,[11]  offsetting earnings against previous year tax losses, or by incurring new, costly expansions to eat up profits in the current year.

It’s obviously nice to lower corporate taxes, but nothing is as nice as being able to influence the estate tax.

Estate Tax

Now it gets REALLY interesting for Adelson.  Bush-Cheney managed to eliminate the Estate Tax for one year in 2010,[12] but that kind of success is like flopping a low st when the other guy thinks he’s sitting pretty and ready to go in on pocket Aces…in other words, it happens rarely and it’s the greatest feeling in the world.[13]  Realistically, a 10% change in the estate tax rate would fully satisfy Adelson.  Because if he dies with a $20,000,000,000 estate, those numbers still multiply out for the following expected value:

$20,000,000,000 x  10% x 40% x 25% = $200,000,000

An expected value of a $200,000,000 million one-time payout upon his death certainly justifies a large investment in GOP candidates!

Of course, unlike the other taxes above, Adelson would only reap those rewards once, from the other side of the grave.

On the positive side, however, all of the other expected values for income, dividend, capital gains, and corporate taxes are annual expected values.  Meaning, to make this as perfectly clear as a royal straight flush, Adelson wins the expected value every single year that he can influence tax rates to go lower through a GOP victory.[14]

When I add up the annual expected value of changes in tax rates due to a GOP victory, I get to $33,000,000 per year, plus a one-time $200,000,000 estate tax win.  And for that kind of payout, you only need to invest $150 million every four years.  At that point, you’re playing blackjack after the gorilla has crossed his arms to signal the count is right.[15]  Or more plainly, those are some good odds.

In sum, Adelson should be investing even more in GOP candidates, as he’s getting back more in expected value than he’s giving.  Which, as a casino guy, he knows perfectly well.  Hence, the plan to double down next year.



[1] Included an estimated $100 million to help nominee Mitt Romney, a man he tried very hard to defeat during the primary by propping up Newt Gingrich’s chewing gum and paper bag campaign in the Spring of 2012.

[2] Adelson may very well average better than a 10% annual return on his assets, but I’m just going to estimate with round numbers to make my life and the math easier.

[3] I’m not at this point literally speaking from experience.  But like all Americans, I believe the fact that I am not yet earning $2 Billion per year is just a quirk of timing.  As John Steinbeck reportedly said: “Socialism never took root in America because the poor see themselves not as an exploited proletariat but as temporarily embarrassed millionaires.”

[4] I’m picking a single ‘average’ again to make my math easy.  This number is based on the Iowa political market’s implied rates.  I’m a big fan and participant in the online political trading markets supported by the Iowa Business School.  Between July 2011 and just a few days before the election, the implied odds of the Republican presidential candidate of winning fluctuated between 35-50%, with just a month above that range in the Fall of 2011, and a few weeks below that in September 2012, before the first televised debate.

[5] This may be too low.  The Bush-Cheney Administration, in gambling terms, managed to ‘run-the-table’ on lowering tax rates that mattered to people like Adelson. (I.e. dividends, capital gains, and estate taxes)  Other Republicans, especially in the face of today’s hefty deficits, would have a harder time reproducing their success.

[6] Heck, this being the interwebs and all, you’re free to put on your troll hat and call me either a socialist drone or a capitalist dupe depending on where your own views took root.  It’s a free country.  Or at least “it used to be a free country before those [fill in the blanks: Communist/Socialist/Corporatist/Fascist] jack-booted SWAT teams of the [fill in the blank: Bush/Obama] Administration started clandestinely snuffing our last remaining freedoms.  Uh, also, pass me the Cheetos.”

[7] Pffffhht, nothing more than enough to occasionally play the penny slots.

[8] Other similarly situated individuals will do the same before the end of the year, such as Oracle’s Larry Ellison. Founding entrepreneur-owned firms like Microsoft, Dell, Ralph Lauren, Nike and Gap may be expected to do the same.

[9] For more on how tax policy encourages or discourages work, see my post here.  To sum up: Your government would like you to earn a living through 1. Receive gifts and inheritance (0% taxes for the first $5 million) 2. Make money with your money pile (0% on Triple Tax Free bonds up to 15% taxes on capital gains and dividends) and 3. Earn a salary (up to 35% tax on ordinary income).

[10] I just picked this because that way I can say Adelson earns an even total of $2 Billion per year, which sounds about right.

[11] Earning money overseas and declining to ‘repatriate’ the earnings, something Microsoft, HP and other tech giants do successfully.

[12] New York Yankee’s irascible owner George Steinbrenner famously benefitted his family to the tune of hundreds of millions of dollars by dying in 2010, the best of all estate tax years to die.  Is it ok to mention here, apropos of nothing, that I hate A-Rod?  I’m going to answer my own question: “Yes.  A-Rod sucks.”

[13] Except for that part about your dead relative who left you money in the estate.  That part is still sad.

[14] I haven’t even got into State level taxes.  But in a discussion with my uncle about the value of paying for GOP candidate victories, he rightly pointed out the risk/reward for political investment and tax savings is probably even more attractive at the state and local level.  He said it best: “You think paying for a US Congressman is good value?  You should see how cheap it is to buy a state or city official!”

[15] Please remind me to do a Bankers Anonymous review of Bringing Down the House, which would make this analogy explicable if it doesn’t already make sense.

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SHHHHHH…Please Don’t Talk About My Tax Loophole

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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