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 keep. That’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.
[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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President Obama recently announced a series of tax changes he will propose or at least politically push for in the coming year.
