An internationally recognized tax expert told me a few months ago that the widely-mislabeled “carried interest” loophole was on its deathbed, that the only uncertainty was how long it would take for it to be dispatched. As much as that is an outcome sorely to be desired, I’m leery of making premature calls of victory, particularly against the plutocratic classes. Nevertheless, the very fact of a PBS video yesterday on this very topic, plus a key aside in it, supports this reading.
First, a bit of background. The reason the “carried interest” label is a misnomer relates directly as to why it is also a tax abuse. Money managers like private equity and hedge funds enter into fee arrangements that include what the IRS calls a “profits interest” and a layperson would describe as a profit share. These firms enter into a prototypical “2 and 20” fee structure, meaning a management fee of 2% per annum of the committed capital plus 20% of the profits, usually after a hurdle rate is met.
Due to clever tax structuring, that 20% is taxed at a capital gains rate even though the managers have no or only a token amount of capital at risk (as in the investors generally require that the fund manager invest some of his capital alongside that of the investors, but it is typically in the 1% to 3% range, and in many cases, that amount isn’t actual cash, but instead a deferral of some of that 2% management fee, which by definition is excessive if the manager is in a position to defer it.*). In other words, they are being taxed at a preferential capital gains rate on what by any commonsense standard is ordinary income and should be taxed at ordinary income rates.
The PBS video below is striking in that PBS is an indicator of leading edge conventional wisdom, and the PBS video signals decline in backing among the elites for this tax dodge. On the one hand, the segment begins with a tiny demonstration against the scheme at a hedge fund conference held at Bloomberg. This could easily have been framed to show how marginal the protestors are. Instead, PBS gave air time to the attractive and articulate leader of the group. And it widens out to show that these opponents have support from an organization called Patriotic Millionaires as well as some straight-shooters in the money management industry, such as hedge fund manager Jim Chaonos.
What was particularly revealing was the stray comment at 4:45: that PBS could find no one in the money management industry who would speak in support of this tax break. Mind you, Steve Schwarzman of Blackstone was so irate about threats to end this loophole in 2010 that he famously compared them to the Hitler invading Poland in 1939.
If you watch the video, you’ll see the only defenders of this tax ploy are from Grover Norquist’s Americans for Tax Reform, which can be relied upon to make extreme arguments for any tax gimmick, and indirectly, the Private Equity Growth Council. But PBS does not have a Private Equity Growth Council spokesman in the segment; it relies instead on a video** which gives a recitation of the party line on the carried interest tax break, which money managers then debunk.
Interestingly, in his effort to defend the carried interest device, Ryan Ellis of Americans for Tax Reform asserts that real reformers, as in those who seek to end this abuse, are interfering with how partnerships were meant to work. In fact, independent tax experts will tell you that partnerships were never meant to be a vehicle for large-scale, impersonal investments. They were envisaged as a mechanism for small ventures and businesses that by nature were owner-controlled, such as law firms, to have a less-burdensome way of organizing themselves from a legal and tax perspective. The US stands apart in allowing the partnership form of organization to be stretched to the degree it has been.
Our tax maven also points out that when (not if) the mislabeled “carried interest” tax loophole is closed, many of the money managers will be able to achieve similar tax benefits by creating a true carried interest, as in borrowing money from their investors to purchase an interest in the fund. However, this would still be a considerable improvement on the status quo, in that the fund manager would lose money if their funds did badly, unlike their current “heads I win, tails you lose” fee arrangement. That should lead them to take less risk, which particularly in private equity, where the private equity managers get rich even when they leave bankrupt companies in their wake, would be a big step in the right direction.
* The management fee is meant to pay for essential overheads and expenses. If the manager can afford to defer some of the management fee to obtain favorable capital gains treatment, it means the investors are letting him get away with getting a higher management fee than is warranted).
**I am not predisposed to notice this sort of thing, but I saw a lot of phallic symbols in the Private Equity Growth Council video. Do other readers see this as a not-sufficiently-subtle effort at subliminal messaging?