Curried Interest

A recent article in the Wall Street Journal was titled “Congress’s Carried Interest Tax Folly” (May 24, 2010). The subtitle was, “The latest soak-the-rich scheme will mean less capital investment and fewer new jobs.”

I may agree with the sentiments of the headline, but on the facts, the sub-head is all wrong. One only has to turn to the first paragraph of the article, which states that “Congress is preparing to enter into a tax increase in long-term investment,” to find a falsehood. The fact is that Congress is preparing a reversal of a tax break won for many years on the so-called carried interest income of partnership fund managers, not investors.

To make this clear, let’s define the parties. The fund manager arranges for investors (typically pension fund, wealthy family or university endowment) to invest. The cost of the manager’s services includes two fees: one expressed as a percentage of the monies earned (say, two percent per annum), and a second fee that gets paid based on part of the hoped-for eventual success of the investment. The success portion of the fee is called the carried interest. Fund managers are often general partners in partnership investment vehicles, and it is in that specific role — general partners — that the tax on managers’ carried interest is expected to go up.

This is a big concern to some because the investments that many fund managers have been putting money in — LBOs, venture capital, real estate — have not done as well as they did in the late ’90s and early 2000s. The managers are feeling that additional bad news could irrevocably harm their interests, or even their industry. I don’t know if that is true or not, but it is certainly an argument that I would like to hear, as opposed to the poppycock from the Wall Street Journal claiming less investment capital and fewer jobs.

Why is the tax going up? Because Congress is considering a reversal of a curious loophole that heretofore has been available only to the general partners. The loophole treats the general partner’s carried interest as a long-term capital gain.

But carried interest is not an investment. It is simply a contractual arrangement made by a fund manager seeking — dare I say it? — a tax on the results earned by the capital. Contractual arrangements of this type have traditionally been seen by the IRS as ordinary income — the same way royalties on music, a contractual arrangement relating to uncertain future income, is seen.

For individuals and most corporations, royalties and carried interest both get taxed at ordinary rates.

So if Lady Gaga (the person) sings a song and gets taxed at ordinary rates, why would we give preferential tax rates to her if she formed a partnership to collect royalties? We wouldn’t.

So why would we for certain fund managers?

Power politics, defined here as wealthy fund managers lobbying for a loophole, is the only difference. The unwinding of the advantage is being portrayed as an uneconomic venture when, in fact, it is simply reversing the unfair, rent-seeking gain that the partnerships are seeking over the rest of us.

To test the veracity of the argument, consider this: if the taxing of carried interest on managers is changed back to its original contractual basis, will the investors — the pension funds that provide the capital for the venture — invest any less?

Or putting it another way, if Lady Gaga were to form a partnership and her agent is taxed differently, would she sing any less?

I don’t think so. And if you counter that the price of funds management will go up because the tax treatment is being changed, tell me this: did it go down when the industry got its bargained-for exemption?

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