JOHN STEELE GORDON: CARRIED INTEREST IS NOT A “CAPITAL GAIN”
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The question of how to fairly and equitably tax capital gains has been a political problem since the modern personal-income tax was adopted in 1913. Actually, this question has been one of the drivers transforming the tax code from its original 14 pages to its current Bibles-long mess. One of the complications, a cause of much recent controversy, is known as “carried interest.”
But first some background. Originally, capital gains were taxed as ordinary income, and capital losses were deductible against ordinary income. In 1921, taxes on capital gains were capped at 12.5% but the deduction of capital losses against ordinary income continued. Then the stock market crashed in October 1929 and the Dow Jones Industrial Average declined 90% by the summer of 1932.
Many wealthy men had large, unrealized capital losses. They sold stock to establish the losses but immediately bought the stock back, then deducted the losses against their other income. In one celebrated episode J.P. MorganJPM +0.93% Jr. admitted in a congressional hearing that, thanks to the treatment of capital losses, he paid no income taxes in 1931 and 1932.
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After a political uproar Congress changed the law in 1934. Now individuals who sold stock at a loss had to wait a month before buying it back to be able to deduct the loss—and capital losses could only be deducted against capital gains (and initially $1,000 of ordinary income).
While the exact rate has varied, taxing long-term capital gains at lower rates than ordinary income has been the norm ever since, although the Reagan tax reform of 1986, which lowered the top marginal rate on ordinary income to 28%, also raised the rate on capital gains to the same 28% from 20%. The capital gains rate was lowered in 1997, back to 20%, under President Clinton in order to raise government proceeds—a successful example of the Laffer curve at work. The rate was lowered again in 2003, to 15%.
One of the artifacts of the tax code is that it treats “carried interest”—a share of the profits reaped by managers of an investment fund—as a capital gain. To most of us, this is a matter of little or no practical importance—but it is a big deal indeed for the managers of many private equity funds and some hedge funds.
Managers of these funds are compensated for their services in two ways. One is the annual management fee, usually 1% or 2% of a client’s investment. The other is a share in the net profits of the fund’s long-term investments. That share is often 30% or even more.
The management fee is taxed as ordinary income, but the long-term profits of investment are taxed as a long-term capital gain, for both clients and hedge-fund managers.
There is no doubt that the profits are true capital gains for the clients of these funds. They risk their money and hold the investment over time; if it loses money they experience a capital loss. Not so for the managers of these funds, who share in the gains but not the losses. They do not put their own money at risk; the reality is that the compensation for their services is income and should be taxed as such. (Of course when fund managers invest their own money their profits should be taxed as a capital gain.)
To defend the favored treatment of carried interest, private-equity and hedge-fund owners argue that their share of the customers’ gains is analogous to “founders stock,” which is granted to the founders of a company when it goes public, even though they may not have personally invested money in the venture.
This analogy is bogus when the companies in which a fund is invested are not actively managed. A founder has a bright idea. He works hard to convince others of its worth so that they will invest in it. He works hard to get the company off the ground, investing his time and his sweat equity in the business (not to mention the forgone income from the 9-to-5 job he could have had instead). He is risking a lot: a substantial portion of his working life, his reputation, his potential current income, etc.
What does a hedge-fund manager risk? His is an on-going business, not a start-up. His business is, in effect, giving investment advice to clients. If his advice nets to a profit he is rewarded with a portion of the gain. How does that differ from, say, a lawyer taking a case on a contingency basis and sharing in the award when the case is successfully settled or won? The lawyer is giving legal advice and being compensated for giving good advice. But that compensation is taxed as ordinary income.
Moreover, much of the investment advice actually comes from the staff of a hedge fund, not the partners. The staff does much of the hard work of investigating investment possibilities. They receive salaries for their advice and are liable to pay taxes at ordinary rates.
Unlike Warren Buffett‘s phony self-example—where he ignored the corporate income tax paid by Berkshire HathawayBRKB +1.61% and thus claimed to pay a lower tax rate than his secretary—carried interest is a genuine case of the staff paying higher income-tax rates than the boss. And it is flat-out wrong.
Mr. Gordon is the author of “An Empire of Wealth: The Epic History of American Economic Power” (HarperCollins, 2004).
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