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Carried Interest to be (mostly) Taxed as Ordinary Income
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The Happy Warrior



Joined: 10 Feb 2010

PostPosted: Mon Jun 07, 2010 5:07 pm    Post subject: Carried Interest to be (mostly) Taxed as Ordinary Income Reply with quote

At the end of May, the House approved an Unemployment Benefit Extension, mainly to keep 200,000 PER WEEK from losing unemployment benefits due to having been collecting unemployment for six months or more, and also to continue COBRA benefits. Of course, there's lots of frivolous tax cuts (like deductions for NASCAR tracks), but there are about $57 billion in tax increases as well. One of the tax increases is for oil ($11 billion, quadrupling to 34 cents the per-barrel tax that oil companies pay into the Oil Spill Liability Trust Fund). But the most publicized tax increase redefines carried interest as ordinary income.

What is carried interest?

Quote:
Carried interest or carry, in finance, is a share of the profits of a successful partnership that is paid to the manager of the partnership (a private equity fund or hedge fund) as a form of compensation that is designed as an incentive to the manager to maximize performance of the investment fund. A manager's carried interest allocation is in addition to any investment that the manager may have in the private equity fund or hedge fund.

In private equity, in order to receive carried interest, the manager must first return all capital contributed by the investors, and, in certain cases, the fund must also return a previously agreed upon rate of return (the hurdle rate) to investors. Hedge funds often are able to pay carried interest annually.

The manager's carried interest allocation will vary depending upon the type of investment fund and the demand for the fund from investors. In private equity, the standard carried interest allocation historically has been 20% for funds making buyout and venture investments. Carried interest rates among hedge funds have historically also centered around 20% but have had greater variability than those of private equity funds, occasionally reaching as high as 50% of a fund's profits.


Change in Carried Interest Passes the House

Quote:
The change would mean that 75% of carried interest, or the amount a private investment manager earns from the firm’s performance, would be taxed at ordinary income rates, which can be as much as 35%, instead of the capital gains rate of 15%. The remaining 25% would be taxed as capital gains.


Michael Kinsley has an article on this, called Discrimination in the Top Tax Bracket. Actually, the title is not only ironic, but misleading. Treating carried interest as ordinary income will treat hedge funds and private investment more like corporate tax rates and the income earned by corporate executives. In this sense, treating carried interest as ordinary income actually eliminates discrimination. And Kinsley veers off a strong point to grind an old (and I think feeble) axe of his: he wants the ordinary income and capital gains distinction destroyed.

So a number of issues for us to discuss that are central to the topic:

(1) What do we think of the new employment benefit extension?

(2) What do we think of treating (most of) carried interest as ordinary income?

(3) What do we think of capital gains treatment in general?

(4) And even more generally, what about corporate, private equity, and hedge fund taxation?
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mises



Joined: 05 Nov 2007
Location: retired

PostPosted: Mon Jun 07, 2010 7:24 pm    Post subject: Re: Carried Interest to be (mostly) Taxed as Ordinary Income Reply with quote

Good topic.

Quote:
(1) What do we think of the new employment benefit extension?

The extension to unemployment benefits has been the one major non-banking policy I've advocated for the past 3 years. There will be no rebound in employment for a long, long time. These benefits are going to cause the natural rate of unemployment to rise, but that is a small (and temporary) price to pay for keeping millions of families above the water.

I don't know if employment will ever recover to 2005 levels. Peak oil and debt saturation are a deadly combo.

(2) What do we think of treating (most of) carried interest as ordinary income?

It is sensible. The money changers add little value to the economy but extract huge rents. Private equity has laid a time bomb as well:

http://online.wsj.com/article/SB125676804216914301.html

It is not fair to tax a productive member of society at a higher rate than a corporate raider. If we want to have a progressive system then actually build one, instead of the present situation where Buffet pays a less % in tax than his secretary.

(3) What do we think of capital gains treatment in general?
(4) And even more generally, what about corporate, private equity, and hedge fund taxation?

Not sure.
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mises



Joined: 05 Nov 2007
Location: retired

PostPosted: Tue Jun 08, 2010 7:22 am    Post subject: Reply with quote

Related to this, Latvia has a 54% flat tax on labour (that is 24% tax and a bunch of insurance etc fees) and a 1.5% tax on property.

The best situation is one where the productive areas of the economy are not taxed at all (labour) and the rent-seekers are taxed heavily. A factory worker should pay zero in taxes on his income. His employer should pay zero in taxes/fees to employ him.
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ontheway



Joined: 24 Aug 2005
Location: Somewhere under the rainbow...

PostPosted: Tue Jun 08, 2010 7:50 am    Post subject: Reply with quote

mises wrote:
Related to this, Latvia has a 54% flat tax on labour (that is 24% tax and a bunch of insurance etc fees) and a 1.5% tax on property.

The best situation is one where the productive areas of the economy are not taxed at all (labour) and the rent-seekers are taxed heavily. A factory worker should pay zero in taxes on his income. His employer should pay zero in taxes/fees to employ him.



Taxes on income of any kind and taxes on property of any kind should all be avoided. These taxes cause massive economic distortions which cannot be eliminated no matter what system is devised. Focusing on interest, rent, dividends, land or other such income results in even greater damage and distortion than taxing labor. The distortions only disappear when the taxes are abolished. Income and property taxes suck massive amounts of manpower and brainpower out of the economy.

As the world becomes more complex, this loss of the smartest people into the tax and accounting professions (hundreds of thousands of highly educated and high IQ professionals who could have put their talents to better uses) is a terrible brain drain that takes talent away from science, engineering, medicine, education etc. When we see disasters happening due to bad decision making, poor maintenance and bad design, one contributing factor is that the smartest people are not available to work in these fields.

The least unfair tax system (since no tax system is fair) that eliminates most economic distortions and allows us to make use of our limited pool of talented individuals would be a flat, sales tax, levied evenly on all new goods and services across the board, capped at a maximum rate of 10% to be shared by all levels of government.

In addition, all levels of government must be prohibited from running a deficit, prohibited from exceeding the 10% total cap, and prohibited from borrowing of any kind. The government must reestablish gold backing for the dollar and must not be allowed to issue new money unless it is backed by new deposits of gold (or possibly silver) into the vaults of the money issuing bank.
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mises



Joined: 05 Nov 2007
Location: retired

PostPosted: Tue Jun 08, 2010 4:56 pm    Post subject: Reply with quote

http://www.businessinsider.com/eddie-lampert-tax-dodge-2010-6

Quote:
A proposal before the Senate would eliminate the special tax setup that allows hedge fund and private equity managers to count a major portion of their income as capital gains, rather than income.

So, not surprisingly, investors are already making moves to dodge the bite.

Bloomberg reports that billionaire Eddie Lampert has given himself a direct $829 million of Autozone stock from his fund to himself.



http://nvcaccess.nvca.org/index.php/topics/public-policy/107-nvca-reaction-to-senate-carried-interest-proposal.html
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The Happy Warrior



Joined: 10 Feb 2010

PostPosted: Tue Jun 08, 2010 5:21 pm    Post subject: Reply with quote

mises wrote:

http://nvcaccess.nvca.org/index.php/topics/public-policy/107-nvca-reaction-to-senate-carried-interest-proposal.html


Quote:
This morning the Senate Finance Committee released its version of H.R. 4213 including a new provision for carried interest taxation. Unlike the House-passed version of the bill which would change the taxation of carried interest income to 75 percent ordinary income and 25 percent capital gains, the current Senate version proposes a 50 percent ordinary income and 50 percent capital gains split beginning in 2011 (as a transition rate) moving to a 65 percent ordinary income and 35 percent capital gains split beginning in 2013 and beyond. That rate would be reduced to 55 percent ordinary income and 45 percent capital gains rate for investments held longer than 7 years.


Even the Senate agrees the majority of carried interest should be treated as ordinary income. It should, perhaps even in its entirety. Carried interest is compensation for management of a hedge fund. In this sense, it is no different than the super-sized executive compensation CEOs receive.

BTW, there's nothing wrong with tax dodging. If the IRS permits it, then its legal. Its tax. Its pretty black and white. Either its legal or its illegal.

The problem is how to craft legislation that captures the most income while preserving fairness. This is not easy.
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Fox



Joined: 04 Mar 2009

PostPosted: Tue Jun 08, 2010 7:17 pm    Post subject: Re: Carried Interest to be (mostly) Taxed as Ordinary Income Reply with quote

The Happy Warrior wrote:
(1) What do we think of the new employment benefit extension?


I support it. I generally don't think it's true in the current environment that people are simply turning down work due to the fact that they have unemployment benefits. People are desparate, jobs are getting a massive number of applicants per opening, and there's not much the average person can do except apply as much as possible, make themselves look as attractive as possible, and hope. Even applying for a position you're overqualified for is unlikely to turn out well; employers realize that hiring overqualified people is likely to result in that person leaving the position as soon as they're able to and are as such relucant to hire such individuals. Unemployment benefits are a far better use of our funds than many other things we've been spending on lately.

The Happy Warrior wrote:
(2) What do we think of treating (most of) carried interest as ordinary income?

(3) What do we think of capital gains treatment in general?


Income should be income, no matter its source. Different types of income being taxed differently is, in my estimation, a needless complexity instituted with the intention of benefitting certain parts of the population (in this case, the ultra-rich).

The Happy Warrior wrote:
(4) And even more generally, what about corporate, private equity, and hedge fund taxation?


When corporations like Goldman Sachs are bringing in massive profits and paying incredibly low tax rates, it's clear the system's in need of massive reform, but I don't know how.
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The Happy Warrior



Joined: 10 Feb 2010

PostPosted: Tue Jun 08, 2010 9:28 pm    Post subject: Re: Carried Interest to be (mostly) Taxed as Ordinary Income Reply with quote

Fox wrote:


The Happy Warrior wrote:
(2) What do we think of treating (most of) carried interest as ordinary income?

(3) What do we think of capital gains treatment in general?


Income should be income, no matter its source. Different types of income being taxed differently is, in my estimation, a needless complexity instituted with the intention of benefitting certain parts of the population (in this case, the ultra-rich).


That's Michael Kinsley's position as well. I don't think it does merit to the proponents of the distinction (they include me).

Note that short-term capital gains (STCG) are taxed at the same rate as ordinary income. Only long-term capital gains (LTCG), assets held for at least a year and a day, are given favorable capital gains tax treatment. There's a principal here. Taxes are due during taxable events, such as the sale of property or stock (both of which qualify as capital gains). Its seen as unfair to tax in one year gains which have accumulated over more than a single year. Take, for example, a farm, on which many improvements have been added over ten years. Initially, the farm was purchased at $200,000. But after improvements (and let's for simplicity's sake ignore possible deductions for improving property), the farm is worth $400,000. The income on the sale will be $200,000, all due the year the sale is made.

If the LTCG-ordinary income distinction is destroyed, that farmer's income jumps to $200,000 in one year, when arguably it should have been distributed as $20,000 in income over the entire life of the farmer's ownership (and there's no way to know what it well sell for, which is the argument against trying to tax the appreciation year-by-year). This would put the farmer into a radically higher tax bracket for the year, if the farmer's ordinary income was, let's suppose, the US median family income ($52,000). He would thus owe more taxes than equity would say he should.

Note also that LTCG rates are progressive, based on the individual's marginal gross income. So those with very little income and living off of stock sales (like the retired) may be taxed as little as 5%. Also, this year, dividends on stock will be taxed as ordinary income (it used to be dividends were given capital gains rates, even though they were not themselves recognized as capital assets, and how could they be?).

I personally think dividends should be taxed as ordinary income, carried interest as ordinary income, and the LTCG rate should be allowed to sunset this year to 20%. But I disagree with Kinsley strenuously that capital gains is a meaningless distinction meant to benefit the rich. Its a meaningful distinction meant to prevent inequity on the sale of investment income, and is a distinction recognized by many developed countries worldwide.
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Fox



Joined: 04 Mar 2009

PostPosted: Tue Jun 08, 2010 10:50 pm    Post subject: Re: Carried Interest to be (mostly) Taxed as Ordinary Income Reply with quote

The Happy Warrior wrote:
Note that short-term capital gains (STCG) are taxed at the same rate as ordinary income. Only long-term capital gains (LTCG), assets held for at least a year and a day, are given favorable capital gains tax treatment. There's a principal here. Taxes are due during taxable events, such as the sale of property or stock (both of which qualify as capital gains). Its seen as unfair to tax in one year gains which have accumulated over more than a single year. Take, for example, a farm, on which many improvements have been added over ten years. Initially, the farm was purchased at $200,000. But after improvements (and let's for simplicity's sake ignore possible deductions for improving property), the farm is worth $400,000. The income on the sale will be $200,000, all due the year the sale is made.

If the LTCG-ordinary income distinction is destroyed, that farmer's income jumps to $200,000 in one year, when arguably it should have been distributed as $20,000 in income over the entire life of the farmer's ownership (and there's no way to know what it well sell for, which is the argument against trying to tax the appreciation year-by-year). This would put the farmer into a radically higher tax bracket for the year, if the farmer's ordinary income was, let's suppose, the US median family income ($52,000). He would thus owe more taxes than equity would say he should.


You articulated that very well. It's certainly given me something to think about. I like the idea of simplicity in taxation, but the situation you describe does seem like a problem.
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rollo



Joined: 10 May 2006
Location: China

PostPosted: Wed Jun 09, 2010 12:49 am    Post subject: Reply with quote

Great topic. Informative post. have little to add but I think it should be treated asiincome. it is simpler, non punative, doesnt stiffle investment.
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gakduki



Joined: 16 Jul 2009
Location: Passed out on line 2 going in circles

PostPosted: Thu Jun 10, 2010 4:56 pm    Post subject: Reply with quote

(2) What do we think of treating (most of) carried interest as ordinary income?
Many general partners can be paid a little excessively if they are skilled (lucky), but people still buy into these funds so all those limited partners have no real complaints. Besides the general partner does take a huge amount of risk. Carried interest isn't always paid. At least with the chance of reaping a huge reward, the GP is more likely to do a good job and help all those LP's make some cash. I must admit, as the average person cannot invest in private equity; it is a system only available to the wealthy elite.
(3) What do we think of capital gains treatment in general?
Capital gains taxes should not be treated the same way as income tax, as someone pointed out, they definetly should be spread out across the years. Favorable taxation policies promote savings. Savings, for most of those Americans who have no concept of what they are, are one of the few ways to promote growth, taxing them more favorably is beneficial.
(4) And even more generally, what about corporate, private equity, and hedge fund taxation?
Lets tax em to death so they leave the country or spend even more money lobbying politicians, hiring accountants, and lawyers. The best and most efficient sort of tax albeit the most regressive tax is a unit tax. Oridnary income tax is the easiest way to get tax, ordinary people cannot afford good accountants, lawyers and lobbying. They will not leave the country if taxes too much. A higher VAT is the best thing to do.
Don't corporations who employ us indirectly pay some of our taxes by having to compensate us more for the work we do? Taxation will not dissapear and the best way to tax is the way that will extract the most taxes possibly while maintaining growth. Instead of arguing about taxes, and who to tax, we should be focusing on what to do with the taxes. Going into huge debts and funding useless wars is the problem. I have no problem being taxed if it is for infrastructure that will lead to growth.
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mises



Joined: 05 Nov 2007
Location: retired

PostPosted: Mon Aug 16, 2010 8:02 am    Post subject: Reply with quote

http://www.newsweek.com/2010/08/15/schwarzman-it-s-a-war-between-obama-wall-st.html

Quote:
Blackstone’s Stephen Schwarzman: Obama Taxing Private Equity is “Like Hitler Invading Poland”

President Obama and the business community have been at odds for months. But in July the chairman and cofounder of the Blackstone Group, one of the world’s largest private-equity firms, amped up the rhetoric. Stephen Schwarzman—the leading John McCain supporter in a firm that, in 2008, gave more money to Obama—was addressing board members of a nonprofit organization when he let loose. “It’s a war,” Schwarzman said of the struggle with the administration over increasing taxes on private-equity firms. “It’s like when Hitler invaded Poland in 1939.”

What isn't like Hitler? Fine. Let's have a war. Obama should declare war on the financial parasites. How many divisions has Schwarzman?

http://www.npr.org/templates/story/story.php?storyId=120391729
Quote:
Private equity firms buy undervalued or underappreciated companies, impose short-term improvements and sell them for a fast profit. Some of the companies they've bought include Hertz, La Quinta, Dunkin Donuts, and Toys R Us. Josh Kosman, a private equity expert, says that the way the firms have been able to buy these businesses — through leveraged buyouts — means the majority of the money for the buyout has come from loans that the firms dump on the company they're supposedly fixing.

Now burdened with debt, many of those companies owned by private equity firms are in danger of defaulting. In a new book, Kosman writes that it's likely half of the 3,188 American companies bought by private equity firms between 2000 and 2008 could collapse. His book is called The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis.


http://online.wsj.com/article/NA_WSJ_PUB:SB125676804216914301.html

Quote:

...

The debt piled on companies amid the decade's $1 trillion buyout boom is coming due. The only question is about the extent of the fallout. The day of reckoning could simply be disruptive for the parties involved, or it could bring down the whole economy in much the same way bad mortgages broke confidence in the credit markets, effectively grinding them to a halt.

Witness Hilton Worldwide, a portfolio company of Blackstone Group LP. Like almost every private-equity buyout, Blackstone acquired Hilton by putting down about 20% of the deal price. The rest was financed by borrowing, except Blackstone didn't assume the debt, Hilton did.

Now Blackstone is in talks with Hilton's creditors to cut $5 billion from the $20 billion debt load carried by hotel and resort chain. Blackstone may pay down some of the debt at a discount in return for taking a bigger equity stake. (See WSJ story on Hilton.)

Hilton, like many companies, has been hit hard by the recession. On top of their massive debt, private-equity-owned companies such as Hilton pay dividends and special fees to the PE firms that own them. It's a squeeze that leaves companies little choice but to cut. Hilton probably will survive. It's Blackstone's biggest company and it would be a massive embarrassment if it went bankrupt. But there are hundreds, maybe thousands more companies in danger of defaulting, according Josh Kosman, author of the forthcoming book, "The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis." (Mr. Kosman is a reporter at the New York Post, which like The Wall Street Journal is owned by News Corp.)

Mr. Kosman argues that between 2011 and 2015 half of private-equity-owned firms, employing 3.75 million, will collapse. If the companies eliminate half their workforce, the impact would be 87% greater than the jobs lost to the North American Free Trade Agreement, and about two-thirds of the 2.6 million jobs lost in 2008.
Barbarians by Any Other Name

Even if the impact of the massive debt is less than catastrophic, it may be a good time to reconsider just what private equity brings to the collective. Private-equity firms do often bring discipline and efficiency to their targets.

But often companies are gutted, stripped and hamstrung for the enrichment of private-equity barons such as Stephen Schwarzman and Henry Kravis, whose expensive tastes are well known.


There are a couple of well-known examples. In August 2007, the Journal profiled workers at Travelport Ltd., a Blackstone-owned company that laid off 10% of its workforce. Another 20% left voluntarily. Blackstone slashed costs and piled on more debt, effectively paying itself back the $1.1 billion it had invested to buy the company.

Simmons Bedding Co., a venerable American brand that in recent years has passed through the hands of five private-equity funds, including Thomas H. Lee Partners L.P., is now expected to file for bankruptcy protection as it reorganizes. Simmons' lenders stand to lose $575 million. The company cut 20% of its workforce last year. Although Simmons has added new factories in anticipation of better times, it is adding only 100 new jobs.


Companies such as Travelport and Simmons had it rough before the economy turned sour. Now that we're in the Great Recession, they struggle to meet even the most basic obligations -- after paying their respective private-equity owners.

Even if private-equity firms such as Blackstone, Kohlberg Kravis Roberts & Co. and Carlyle Group bring efficiencies and profits to the companies they buy, the unfortunate truth is that much of those profits aren't returned or reinvested in those companies.

Mr. Kosman argues that the toll on companies and customers can be severe, and has been so especially in the health-care area. Private-equity firms have scooped up hundreds of for-profit hospital chains including HCA, the third-biggest buyout of all time. That deal, in which private-equity buyers put down just 12% of the $33 billion purchase price, prompted nursing unions to argue that HCA's new owners were cutting costs at the expense of patients.

Today's barbarians would argue otherwise, of course. They say fears of multiple collapses are overstated, that even if their portfolio companies can't repay their debt, it can be restructured. If assets have to be sold or workers fired, disruption is a natural and healthy process of the economy. And, of course, private equity provides the company's owners -- the shareholders who sell out -- a nice payday for their stakes. Many of these companies are spruced up and resold to the public via stock offerings.

We heard similar arguments from the guys packaging mortgages into securities and the bankers who stuffed their balance sheets with the junk. Nothing can go wrong, and even if it does, it's all fixable, they said.

So why is it that so many of these private deals end up as public disasters?


To save the economy we'll need this war on private equity.
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The Happy Warrior



Joined: 10 Feb 2010

PostPosted: Tue Aug 17, 2010 12:52 pm    Post subject: Reply with quote

I was under (the perhaps incorrect) impression that private-equity bought firms in leveraged takeovers. This gave them control but saddled the acquisitions themselves with debt. If my impression is correct, that would mean private-equity's venom is already coursing through the economy.
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The Happy Warrior



Joined: 10 Feb 2010

PostPosted: Wed Oct 06, 2010 10:06 am    Post subject: Reply with quote

Nah, it won't.

http://www.rollingstone.com/politics/matt-taibbi/blogs/TaibbiData_May2010/213905/83512

Matt Taibbi wrote:
The carried interest tax break is a classic example of how in America constituencies with the means and the bureaucratic endurance to get what they want slowly hack away at the government over time, carving out exemptions to their civic responsibilities while ordinary people suck the proverbial egg. A 100% or 200% tax break for hedge fund and private equity billionaires is not the sort of thing that one passes instantly, by standing up in front of big campaign crowds and urging on a mob; it takes a long time and a lot of behind-the-scenes baby steps.


If you haven't read Taibbi before, you're in for a treat.
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mises



Joined: 05 Nov 2007
Location: retired

PostPosted: Wed Oct 06, 2010 10:11 am    Post subject: Reply with quote

The Happy Warrior wrote:
I was under (the perhaps incorrect) impression that private-equity bought firms in leveraged takeovers. This gave them control but saddled the acquisitions themselves with debt. If my impression is correct, that would mean private-equity's venom is already coursing through the economy.


Yes. It is very serious. Hundreds of thousands of Americans will lose their jobs because of this. I'm not exaggerating.

Quote:
How bad do you think it will get?

The opinions on this shift, but the Boston Consulting Group in late 2008 predicted that about 50% of the companies bought in leveraged buyouts would default on their debt. If half default, and they fire about half of their workers — not the most aggressive estimate — then you're talking about 1.9 million unemployed.


http://www.time.com/time/business/article/0,8599,1942574,00.html
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