Carried Interest

I, along with (seemingly) President Obama, have long been an opponent of the “carried interest” tax treatment on the earnings of hedge-fund managers (for my detailed argument, see: Fewer Happy Returns).  In fact, I believe that this has been one of the driving forces behind our President’s “fairness” obsession to raise taxes.  (Or maybe he is just using it as a convenient excuse?)  This January he already has gotten the capital gains rate increased from 15% to 20% … I suspect, among other things, in order to increase the taxes on carried interest … i.e., tuck it to hedge fund managers.  But, in the process, he is also screwing ordinary middle-class investors.

However, of late I have been curious about how this favorable tax treatment came into being.  I first went to Wikipedia (see: Wikipedia Entry ) where I did not find its genesis … but it does say that it has been an issue since the mid-2000s.  My suspicion is that this tax treatment was initiated within the IRS itself.  As per the Wikipedia entry, there apparently were some unsuccessful attempts by the Democrats to erase this rule in the 2008 to 2012 time frame.  Moreover, there was actually such a law passed in the Democrat-led House of Representatives in 2010 … see: Gibson Dunn Comments.  Curiously, it apparently died (as most things did) in the Harry Reid (D, Nevada) controlled (with an iron hand) Senate.  So, like many controversial issues, the Democrats have been able to have their cake and eat it too.

Clipping Hedge Funds

I criticize President Obama quite a lot.  So when I get a chance to agree with him, I feel to be out of step with myself.  However, his calling for hedge fund managers to pay taxes on their compensation ... as though it were ordinary income ... strikes me as quite rational (see: Huffington Post Story).  The reason that these barons of Wall Street ... such as Warren Buffet ... currently get away with paying 20% (just upped from 15%) on their hedge-fund compensation (which often can runs into the tens, if not hundreds of million dollars) is that it is treated as "carried interest" ... in other words, it is viewed for tax purposes by the IRS as though it were real interest on invested capital.  It most often isn't.  The definition of "carried interest" is:

"A share of any profits that the general partners of private equity and hedge funds receive as compensation, despite not contributing any initial funds. This method of compensation seeks to motivate the general partner (fund manager) to work toward improving the fund's performance."

Rush Limbaugh has also  zeroed in on "carried interest" as possibly being a problem. This could be because the recent raising of the taxes on capital gains from 15% to 20% may have been inspired by this tax loophole  That is, the rest of the country is now paying a penalty for this one taxing inconsistency.  Rush had in the past implied that this compensation represents a fair (interest) return on what these managers initially invested.  It most often isn't.  Or, if it is, is is not allocated according to what percentage their initial investment represents relative to the total hedge fund assets.  This, to me, is wrong ... and needs to be remedied.  The closing of this tax loophole is not going to balance the federal budget (bringing in just a few extra billion dollars), but this unfairness seems to be gnawing at Obama’s (and my) psyche … and should be fixed.   Then maybe we can drop the real capital gains tax rate back to 15%?  That would be fair.

So even though Obama seems to be biting the hand (Wall Street) that has fed him royally, I will support him on this one issue.  But I won't make it a habit.