Closing the Tax Gap – Congress and the “Carried Interest” Tax Controversy

It shouldn’t surprise anyone that the words controversy and Congress are used in the same sentence.  When it comes to legislation the only thing both sides of the aisle can agree on is disagreeing.  Once again this holds true with proposed changes to the tax code.  Surprisingly (or not) lines that were non-partisan have become partisan and are being redrawn again.  What is the controversy?  Well it allegedly begins with the tax gap and focuses in on the tax treatment which appears to be preferential for one group versus another – the compensation of asset management (hedge, investment, real estate, etc) fund managers known as “carried interest” which is taxed as capital gains (a maximum tax rate of 15%) not as regular income (a maximum tax rate of 35% plus other taxes such as Social Security and Medicare).

Terms:

Tax gap: the difference between the actual amount of taxes due the government and the amount collected.  The IRS defines three components:  underreporting, underpayment, and non-filing.

Carried interest: the ownership right to receive a specified share of the profits eventually earned by a fund without having made a substantial (or any) investment of capital into the fund – the right to share in the profits is a result of compensation package for management services.  Managers are compensated for services rendered through this ownership interest in the fund rather than through salaries and wages.

Capital gain: the profit that results from the appreciation of a capital asset over its purchase price.

Attracting Congress’ Attention

While the tax gap has been given the most credit for attracting Congressional attention – like waving a red flag or cape at a charging bull – most agree that the tax gap alone was not sufficient incentive.  several other factors have assisted in bringing the “carried interest” and compensation controversy into the spotlight.  These factors include:

  • the recent increase in small group private equity firms finding the “loophole” in current legislation that enables them to be publicly traded AND still avoid paying corporate income taxes (Note: PTPs, publicly traded partnerships, have been subject to corporate taxation, but within the last year or so highly publicized groups have been able to find ways around the rules.)
  • the rapid growth of “mega” compensation packages for private equity managers
  • economic efficiency – the position that allowing one type of compensation which is similar in nature to other compensation being earned by other industries or groups to be taxed at a lower rate creates a distortion  in the market place
  • revenue loss for other programs – missing the opportunity to tax at the higher rate and have the funds to spend on other programs
  • tax discrimination – once again the rich get richer…those with the money get to make more money by getting a preferential tax rate on compensation for services because that compensation is allowed to be classified differently and taxed at a lower rate

Today’s Perspective – Risk Reward or Compensation

Advocates of the current tax treatment have the perspective that the distribution of “carried interest” has been part of the capital appreciation of the investment fund.  This is the logic underlying this premise”  the fund managers like the investors providing the actual monetary capital are providing assets – in this case the intellectual know-how of managing the investment – and are delaying the compensation, taking the risks,  providing “sweat equity”, and building capital.  It just happens that the investment vehicle for these individuals is intellectual capital.  Since they are providing capital, the gain is a capital gain not compensation for services.

The Other Side – Across the Tax Gap

From the other side, fund managers are being compensated for services.  Services are services and should be taxed as such.  Every other service provider in any other industry is compensated and taxed as income, not capital gains.  The argument that the intellectual capital contribution in the “investment and asset management industry” is an exception from the “service fees are taxable as income” rule just doesn’t hold up.  Other service providers and business people also take risks and have risky forms of compensation.  Some of that compensation includes the following:  performance bonuses, contingency fees, incentive fees, royalties, stock options or grants, business income from most businesses.

Bills, Bills, Bills – S. 1624, H.R. 2834, and H.R. 2785

Both the Senate (S. 1624) and the House (H.R. 2834 and H.R. 2785) have introduced bills which have some impact on the taxation of “carried interest”.  Where these pieces of legislation will ultimately end up and what the final language will be is as yet unknown.  As of the writing of this article, when or even if these bills will actually make it to a vote is anyone’s guess.  The eagerness with which the bills were introduced has been tempered by intense lobbying from a host of sources from the real estate, venture capital, hedge fund, and many, many other industries.  The intense scrutiny and debate on the true impact the changes would have on the economy and the “tax gap”, as well as what is the typical ebb and flow of Congressional and Administration debate on taxes, economic incentives, and the “priorities” of each session may mean that the debate will be tabled until after the 2008 Presidential Election.

These bills take different approaches to the taxation issues and to closing loopholes which have created tax advantages, whether for the PTPs or the carried interest compensation issues.  The Senate and one House bill are narrower and would require some of the partnerships to be taxed as corporations if they are publicly traded.  While the other House bill requires the carried interest income to be taxed as earned income (not at 35% instead of 15%, oh and let’s not forget the Medicare and Social Security taxes…).  Still, one wonders if either side or all parties have examined all the consequences and practical application effects of any changes to the tax code.

The Impact and Incentives – Entrepreneurial Risk Taking, Venture Capital and Other Investment Partnerships

What does the current system mean from a monetary perspective?  Well, if money managers earn $500 million and those earnings are taxed at a maximum of 15%, they may actually be paying fewer taxes than most middle-income wage earners in America do.  Taxing asset management service fees at a lower rate than similar service fees is discriminatory and less efficient for the economy as a whole because it creates distortions from policy rather than market forces.

Keep It Simple S….

If you are going to make changes to the tax code, then arguably it is time to make those changes systematically.  The tax code is complex and well broken as it is.  There are too many opportunities for the informed and creative to find the glaring omissions and ninformed opportunities left behind and for them to use those loopholes to their own advantage.

So keep it simple Senate and House.  Understand the impact. Your motivation for the changes may be attributable to the tax gap.  It may not be.  It may be about groups that are benefiting too much from an understanding of the rules as they have been written and the capital markets as they work.  Too much profit.  Too much incentive.  Whatever the motivation, the reality must not be a disincentive for investment in high-risk projects.  If you truly are intent on changing the tax system to eliminate an “unfair” advantage, then make sure you fully understand the impact to both sides of the equation. What will the impact be to high-risk projects? What will be the economic impact to the technology sector, to urban renewal projects?

A Level Playing Field

Level the playing field by all means, but understand what it actually takes to do that – it isn’t simply a change in tax rates, nor will it be so simple as to reclassify compensation for service rendered from ownership interest (capital gain) to service income (income and employment tax eligible).  What about the impact of the timing of the recognition of the compensation?  The ability to defer the income recognition may be even more significant than the difference in tax rate.  Who is talking about that?  Well?

Reality Check

It is unlikely that the proposed legislation will have a significant impact on the private equity industry.  Why?  Well, as mentioned earlier, it seems as if the calendar for Congress has become a bit too full during this session and next year is already loaded with the Presidential campaign.  Further, even if the hearings and debate continue and all the bills make it to the floor for votes, they would have to be reconciled to a common bill agreed by both houses of Congress.  That takes time, time which gives lobbyists the opportunity to work their magic.  Oh, and even if the bills would pass at their toughest levels, the profits to be made and the “normal” compensation for the deals after “regular” taxes are still incentive enough that most agree, private equity isn’t going to be walking away from very many deals in the long run.

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