Ryan Ellis on Carried Interest

Forbes: Taxing Carried Interest Capital Gains As Ordinary Income Is a Very Bad Idea

By Ryan Ellis, September 4, 2015

Taxing carried interest as ordinary income is a really dumb idea. The title is just being polite.

It makes no sense as a matter of tax policy. It makes no sense if your goal is to soak the rich. It makes no sense if you want to raise money for tax reform. It is the triumph of feelings over thinking, and emotion over reason. It is borne of impassioned ignorance combined with a singular stupidity. It’s populism at its worst and ugliest.

Let’s dive in.

What Is Carried Interest Capital Gains and How Does It Work Under Current Law?

Let’s begin by looking at what we’re even talking about.

Investment partnerships are formed when investors with cash but limited expertise pool their money together and give it to a manager who has that expertise but needs cash. This happens all the time. Universities and colleges, charitable trusts, and pension plans all seek out “alternative investment vehicles” to diversify from stocks, bonds, mutual funds, and cash equivalents. They give their money to (usually) a private equity fund managed by an expert investor, and they step back as limited partners hoping to make a tidy profit.

How does this expert investor get compensated? Usually by something called “two and twenty.”

The “two” stands for the management fee/W-2 salary the investor gets for his labor-his paychecks equal two percent of the assets he is managing. Like any other wage, it’s subject to ordinary income tax and payroll taxes.

The “twenty” stands for the expert investor’s share of the capital gain he obtains for the limited partners. He keeps twenty percent of the capital gains he accrues (above and beyond the original investment), and the remaining eighty percent is left for the limited partner investors-those colleges, charities, and pensions mentioned earlier.

The investor expert’s share of the capital gain is known in the industry as his “carry.” Like any other capital gain, it’s subject to capital gains tax.

The wage paid to the expert investor-the two percent of assets under management equivalent-is taxed as ordinary income. It’s subject to a federal income tax with a top rate of 39.6 percent, a Medicare payroll tax with a top rate of 3.8 percent, and hefty state income tax rates.

The capital gain carried interest realized by the expert investor-the twenty percent of all gains he gets to keep-is taxed as a capital gain. It’s subject to the federal capital gains tax, which is now 23.8 percent (which includes the Obamacare surtax on investment income). State income taxes also apply.

The limited partners face taxation according to their own situations. Most of them are not taxpaying entities (being charities or pension plans), but those that do pay taxes would see the same capital gains tax treatment that the expert investor does. After all, it’s the very same capital gain.

What Tax Changes Have Been Discussed?

Some-like Democrat presidential candidates Hillary Clinton and Bernie Sanders-have called for the capital gain realized by the expert investor to be taxed as ordinary income. Most recently, GOP Presidential candidate Donald Trump has called for hiking taxes on “hedge fund guys” (by which he means private equity, venture capital, and real estate investors), and his bad idea seems to be spreading to other campaigns.

Under this plan, the capital gain allocated to the expert investor would face the same 39.6 percent income tax, 3.8 percentage point Obama surtax, and state income taxes as the wages paid to the expert investor. It’s approximately a 20 percentage point increase in the tax rate on the margin, a huge capital gains tax increase.

If this sounds familiar, it’s because Congressional Democrats made a run at this back in 2007 when they took control of Congress. It failed then because conservatives realized that what was at stake here was not “hedge fund guys,” but the tax treatment of capital gains. A longstanding goal of Democrats is to tax ALL capital gains as ordinary income, and this carried interest capital gains tax hike is a prudently chosen tip of the spear. Wise Republicans should want nothing to do with this trap.

Taxing Carried Interest As Ordinary Income Is Bad Tax Policy

Our tax system taxes income in all sorts of ways. Profits that a corporation make are taxed one way. Profits that an S-corporation make are taxed differently, as are profits made by partnerships and sole proprietorships.

Wages have certain tax rules, as do interest, dividends, capital gains, rents, etc. Most of the time, there’s good reason for these differences.

In the case of capital gains, the tax code has nearly always taxed it at a lower rate than other sources of income for a few reasons. First, a capital gains tax is usually (but not always) a second layer of tax on retained, after-tax corporate profits which have already faced corporate income taxation. Second, the basis of capital gains is not indexed to inflation, and therefore some portion of any capital gain is merely inflation effects. Third, the code has recognized that capital investment is subject to the risk of losses, and therefore a lower rate compensates for this risk.

The point is that different types of income are taxed differently based on their character. They are not taxed differently because we “feel” like someone ought to be paying more or less. Rent is rent. Dividends are dividends. Capital gains are capital gains.

You’ll often hear people saying that the twenty percent capital gains share allocated to the expert investor (the “carry”) is really more akin to labor income, and should be taxed as wages. Hogwash. It’s a capital gain, and wishing it was a wage does not make it so. The investor took money, bought an asset, grew the asset by making it more economically valuable, and sold the asset at a profit. In any rational universe, the resulting profit is a capital gain, plain and simple. It’s demagoguery and sophistry to argue otherwise.

Imagine yourself as one of these expert investors. Part of your earnings is that you get to keep twenty percent of any capital gains you can produce, subject to a tax rate of 23.8 percent. You walk away, in other words, with $7620 for every $10,000 in your share of the gains (I’m ignoring state taxes here for simplicity).

Congress changes the law so that your capital gains tax rate rises from 23.8 percent to 43.4 percent (including the Medicare payroll tax). You want to walk away with the same money after-tax as before. What do you do?

Simple. You negotiate to get a bigger share of the capital gain so that you still make the same money on an after tax basis. Instead of getting twenty percent of the capital gain as your carry, you might get thirty or thirty-five percent. Whatever it takes after you run the numbers (being pretty good at that as an expert investor).

Where does that increased share of the capital gain come from? Your limited partners, of course. More money for you means less money for the universities, charities, and pension plans. Instead of keeping eighty percent of the capital gains, they might be left with only seventy or sixty-five percent. They will still take it, since they need your expert advice and you’re not about to take a pay cut after cash. But those sectors never get made whole.

If the goal is to hurt “hedge fund guys,” mission not accomplished. All that was ultimately done was to hurt pension plans, colleges, and charities. That almost certainly will trickle down to middle class families sending their kids to school, or drawing a traditional pension, or benefiting from a charitable endeavor. It goes without saying that small firms looking for investors will also take a hit.

Taxing Carried Interest As Ordinary Income Won’t Raise Money for Tax Reform

There seems to be an impression that taxing these types of capital gains as ordinary income will be some revenue boon to the government.

Not even close.

Take the Joint Tax Committee’s score of H.R. 1, the tax reform plan introduced by former Ways and Means Chairman Dave Camp (R-Mich.) While this proposal isn’t a direct switch to ordinary income taxation, it’s pretty close and reflects a likely political compromise outcome. The scorekeepers say this idea raises $3.1 billion over a decade.

A more direct tax increase proposal contained in President Obama’s budget puts the revenue yield at $15.6 billion over a decade.

That might sound like a lot of money, but it isn’t by Beltway standards. According to the Congressional Budget Office’s latest numbers, total federal tax revenues over the next decade are expected to come in at $41.6 trillion-with a “t.”

I’m not sure a calculator has been invented to express how small $15.6 billion is as a percentage of $41.6 trillion. It’s absurd this is even being discussed. This is not a serious subject for tax reform.

A Bad Idea Whose Time Has Not Come

Raising capital gains taxes is a bad idea. Doing so because you don’t like the recipients of a certain type of capital gain is a worse one. Donald Trump and the other Republicans running for president should think twice before pandering to this hard Left demagoguery talking point.