Carried Interest Debate is a Waste of Time - Its a Zero Sum Game - 2015 Refresh

There are too many people that have entered the debate about carried interest taxation that don't know what they are talking about.  There are two falsehoods that I'd like to address:

"Hedge fund manager's pay a 20% tax rate on their earnings"
"Hedge fund manager's are cheating the government out of revenues"


Let's address the first falsehood...hedge fund manager's pay a 20% tax rate on their earnings - that is false!!!  Their true Federal effective tax rate is going to be a figure far higher than that.   To prove this, let's look at how fund managers earn their money....they earn management fees and performance compensation.  

1) Management Fee 1%-2%+ on Assets under Management.  That fee is taxed as ordinary income (39.6% Federal tax rate) and hit with self-employment tax (2.9%).
2) Performance Compensation - generally the fund manager will receive 20%+ of the profits of the fund as compensation of positive performance.  This will be taxed depending on who the fund manager is managing money for and how the fund earned its money.   For the money managed for non-US investors and US tax exempt investors and this certainly could be the bulk of the money some managers manage, the fund manager will be taxed on this compensation as a fee as such will be taxed at ordinary income tax rates and also hit with the self-employment tax.  

Generally, its only the earnings on the money that the fund manager runs for US individuals that will be taxed as a profits interest (aka performance allocation..aka carried interest). That is -- they will receive 20% of the profits of a fund, the investors will get the balance of the profits. Accordingly, they will be taxed based on how the profits are earned within the fund

Let's work with an example it's easier to show how little a hedge fund manager may actually pay only 20% of tax on.

• Alpha Fund has $100,000
• Fund Manager A earns a 2% management fee and receives 20% of the funds profits.
• The Fund is split between 50% of US tax-exempt and non-US investors and 50% taxable US investors.
• The Fund earns $10,000 in the following character:
• Dividend Income Qualifying           $1,000
• Dividend Income- Non-Qualifying  $1,000
• Interest Income                              $2,000
• Foreign Currency Gains                 $1,000
• Short-Term Capital Gains              $3,000
• Long-Term Capital Gains               $2,000

The Fund Manager will earn a compensation in the total of 2% x $100,000 = $2,000 + 20% x $10,000 = $4,000.

On that $4,000 of earnings the Fund Manager will pay $1,618 of Federal tax or 40.45%.
Calculated as follows:

$2,000 mgmt. fee x 39.6% +
$1,000 perf fee on US tax-exempt/non-US investors x 39.6% +
$1,400 perf fee on US taxable investors taxed at ordinary income rate x 39.6% +
$ 600 perf fee on US taxable investors taxed at capital gains rates x (20.0% + 3.8% Obamacare tax)

For those that need some help, 40%>20%.

In actuality, many hedge fund managers manage funds such that the funds earn ordinary income thus may actually pay the full 39.6%+ on all of their earnings.  Because of the complexity of the Internal Revenue Code many managers that have high volume of trading simplify their tax accounting by making an election to treat all of the income of their fund (and of their profits interest) as ordinary income as such all earnings management fee and performance fee will be taxed at 39.6%.   There are also many hedge fund managers that don't make this election but may already be paying 39.6% tax rates on all of their earnings because they may not hold securities long-term.

So when we are talking about hedge fund managers only a few may actually pay a rate less than 39.6% and those that pay tax on a lower rate actually only a small portion of those earnings would be eligible for the 20% rate.  Admittedly, private equity funds make most of their money on long-term capital gains but the long-term capital gains tax rate still wouldn't apply to the private equity fund manager's management fees and the performance fees earned on US tax-exempt/non-US investors capital.  

I also can share examples of how in some crazy years such as 2008 and 2011 and potentially 2015 where some fund managers paid a tax rate far higher than the ordinary income tax rate!  

The second falsehood is that these manager's are cheating out the US Treasury of revenue and actually if compensation structures and taxation remain the same the US government is bound to earn more from the status quo rather than if the tax law was to be changed.

Let's look at a simple example...

• Fund manager A manages Alpha Fund.
• Alpha Fund earns $100 long-term capital gain.
• Investor X owns 100%.

Let's take an example if a fund manager doesn't charge a profits interest.

• Investor X will pay $20 tax on the capital gain that the fund earns.

Now let's say the Fund manager receives a 20% profits interest.

• Investor X will pay $20 x 80% = $16 of tax on his share of capital gains.
• Fund Manager A will pay $20 x 20% = $4 on his share of capital gains.
• Total of $20 of tax on the capital gains.

Now let's look at this proposal to tax carried interest as ordinary income.  Presumably, Fund Managers will change the profits interest to an actual fee so investors can get benefit of the expense.

So case under Proposal.

• Investor X will pay $20 of tax on capital gains will get a $8 ($20 x 39.6% ordinary income tax rate) tax benefit for the performance fee expense.  So they will now pay $12.
• Fund Manager A will pay $8 ($20 x 39.6%) of tax on his performance fee.

Again in total its $20 of tax but the shift of the burden goes from the Investor to the Fund Manager.   This is simple stuff and simple math but not sure why so people don't understand it -- including some people that are supposed to be financial market gurus.   Really all this whole huge debate is over who really gets stuck with the tax bill - one rich guy (the fund manager) or another rich guy (the fund investor).   Hedge fund investors understand the issue and live it because they are smart enough and have enough money to deal with it.   But to say we all who aren't hedge fund managers are being screwed is a lie.

The US government isn't being cheated here 1)This is how the law is written and 2) as you see from the example there is no reduction in total tax revenues - its just who pays it.  Actually if we add the self-employment tax and the Obamacare tax on investment earnings.   The US government will be better off having the carried interest taxed as capital gains (thus subject to the 3.8% Obamacare tax) rather than earnings (thus only taxed at self-employment tax rates of 2.8%).

So let's stop the debate - its a waste of time.  Its a zero sum game....also it's making a lot of people look foolish who get up on their soapbox but who haven't taken the time to do the math!