Carried Interests: Can They Effectively be Taxed
Valparaiso University Law School
August 26, 2009
Entrepreneurial Business Law Journal (Ohio State), Forthcoming
During the April 2008 Democratic Debate, former Senator Obama with former Senator Clinton almost referred to the subject matter of this article verbatim at page three of the transcript. (“We saw an article today which showed that the top 50 hedge fund managers made $29 billion last year -- $29 billion for 50 individuals. And part of what has happened is that those who are able to work the stock market and amass huge fortunes on capital gains are paying a lower tax rate than their secretaries. That's not fair.”). As stated by both candidates, the budget is going to be a major source of contention, and revenue raisers, such as the proposed legislation under Internal Revenue Code (I.R.C.) § 710, will be a hot button item. It was estimated by a Congressional committee that the fund managers would save $30 billion in taxes over the next ten years if the rules did not change. As promised, on page 122 of President Obama’s 2009 budget is the proposal to tax carried interest as ordinary income. It is suggested that this change will raise $2.7 billion in tax revenue in 2011.
The initial public offering (IPO) of Blackstone Group stock caused a public and political backlash when an IPO memorandum showed how much built-up gain existed in Alternative Investment Vehicles (“AIVs”). These offerings spurred public interest in the quantitative net worth of the owners of the funds, like Stephen A. Schwarzman, a co-founder of Blackstone, and the tax rates paid by these owner- individuals. Congress also began to focus on the tax loop-holes allowing these owner-individuals to monetize their carried interest at a significantly reduced tax.
This surge in public interest combined with political needs for offsets to eliminate the alternative minimum tax led several influential lawmakers to seek passage of tax legislation that would reduce the tax incentives currently in place. These tax incentives primarily benefited managers of AIVs. The legislation was introduced most predominately in H.R. 2834, which sought to add I.R.C. § 710 to the Code, changing the treatment of distributions to the service partners from capital gain rates to ordinary income rates. Thus, the bill contains provisions that seek to completely reverse over thirty years of jurisprudence with a shotgun approach in attempting to solve what is deemed an injustice by some.
This article addresses the social equity arguments and the tax and economic theories to solve the perceived problem. Will the managers, if subjected to higher taxes, attempt to maximize the value for the investors? If one believes that there are “enough people who want to be rich,” then there is no reason to further incentivize the fund managers by taxing the fruit of their labor at reduced rates. There will always be ambitious and smart people who would be more than happy to step in and do these services even at higher tax rates. Further, it has been argued that a lower tax rate will not be sufficient to change the behavior of this category of individuals. One would have to demonstrate that fund managers would have to either reduce their current work efforts, if the rates were raised, or that this class of individuals is more sensitive to tax incentives than other professions.
The article then concludes with a thorough discussion of the current law and the proposed changes to solve the social inequity. The article discusses the proposed H.R. 2834 and whether the proposed tax legislation will ultimately be successful in raising revenues as Congress intends. The article concludes with a thorough discussion of the current law and the proposed changes. Under the proposed legislation, the result would be to tax the general partner at ordinary income rates. This would mirror the treatment of nonqualified stock options. The carried interest would still retain the deferral characteristic but would be taxed when they are redeemed by the fund managers at ordinary income rates. However, it is argued that this approach would lead to tax planning such as the utilization of loans.
Number of Pages in PDF File: 41
Keywords: Tax, Carried Interest, Hedge Funds, deferred taxation, H.R. 2834, Code Section 710, Blackstone, Buffett, Rangle, Alternative Investment Vehicles
JEL Classification: K20, K30, K34
Date posted: August 27, 2009 ; Last revised: October 20, 2009