"Carried Interest" is Not the Problem Everyone Wants It To Be

John Steele Gordon’s recent Op-Ed in the WSJ opened with following observation: “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”. Being a business/financial historian, he gives an adequate overview of the history of capital gains and how it has reached its present state. But because he is not an economist or CPA, he disingenously presents a one-sided treatment of the issue of capital gains and “carried interest” without actually exploring the merits of the tax. The result is that Gordon sounds like sour grapes on the wealthy and ultimately, he is wholly unable to answer his own question.

Gordon puts forth the notion that “carried interest” is a “cause of much recent controversy”. This much is true, in that the recently defeated Baucus/Grassley bill was attempting to “fix” carried interest. According to the bill patrons (and also Gordon) the problem is that the hedge fund operators get part of their compensation from relatively low-tax capital gains income.

This is true. But so what? It’s not as though the income isn’t from capital gains. If the law was changed so that the operators were taxed at ordinary income only, it wouldn’t get rid of those gains — it would simply mean that the investors get the benefit of the capital gains lost by the operators. This fixes nothing.

Ultimately such a change, which is again being explored in Obama’s proposed budget, will merely shift the tax benefit from the operators to the investors. This takes a tax break away from people who are working for a living and gives it to millionaires who are just investing – pure hypocrisy from liberals who wish to inflict additional taxes on the wealthy at every step. It make compensation deals for hedge fund operators a bit more complicated (i.e. requiring more assistance from accountants), but the amount of compensation stays revenue neutral.

Therefore, it takes a whopping dose of either incompetence or disingenuousness from Gordon and other carried interest critics to look at the hedge fund industry and proclaim that the hedge fund operator “carried interest” is the problem that needs to be addressed.

What Gordon completely omits from his hedge fund analysis is that the Internal Revenue Code (IRC), as strictly enforced by the IRS, contains rules that require investors to pay tax on investment income while simultaneously denying them an offset for the expenses that were incurred to generate that income. The result is that hedge fund investors generally pay taxes on huge amounts of “income” that does not exist.

It is simply not uncommon for hedge fund investors to pay tax rates of 70-100% or more on the hedge fund income they earn.

Yes, you read that correctly. 100% or more. In fact, in my practice I see a few clients every year forced to pay more taxes on an investment than that investment even earned. This even happened to Mitt Romney, whose taxes I reviewed for various media outlets — which was a story I wrote about but the MSM never covered. True, it is a small percentage of people affected in any given year, but this does not mitigate the blatant unfairness. How does this injustice take place?

It follows from what is the most inequitable provision of the current tax code, namely, the severe limitation on the ability to deduct the necessary expenses incurred by a hedge fund operator in order to earn income: investment fees and expenses, accountant’s fees, legal fees for collecting a settlement, etc.

The tax code requires those expenses — which include virtually all operation expenses of private equity hedge funds, including fees to the operators — to be listed under the category of “miscellaneous deductions”. However, “miscellaneous deductions” may not be claimed until and unless they reach 2% of the taxpayers entire income. The upshot of this is that most taxpayers (hedge fund operators included) do not get to benefit from this deduction. To add further insult to injury, even if taxpayers have expenses which do exceed the 2% threshold, those expenses become addbacks for the dreaded alternative minimux tax (“AMT”).

This taxpayer abuse certainly discourages investment and is a major source of inequity in the code.

If John Steele Gordon and Congress were ultimately concerned with reforming the hedge fund industry, this problem — the inability to deduct necessary expenses incurred while earning income — would be the right one for Congress to fix. Trying to interfere with and fix who gets the capital gain rate in a “carried interest” transaction was a worthless and meaningless endeavor.