Tuesday, January 31, 2012

Here's an article on NRO from someone defending the current tax treatment of so-called 'carried interest".

In particular, I refer to his claim that "Paying carried interest rather than salary simply reallocates the two types of income among the two types of partners.... Nothing gets turned into anything else." I think this is misleading and I dare say, probably intentionally so.

Here's why:

Take a fund with $100 million of profit, split 60/40 between the investor and the fund manager, with each recognizing their share of the distribution as capital gains.

Were the fund to pay the manager compensation of $40 million, the fund would have a net profit of $60 million (pre-compensation profit of $100 million less salary expense of $40 million). The investor would receive the same amount of cash ($60 million) as before, the fund manager would receive the same amount of cash ($40 million) but it would be characterized as regular income and not capital gains.

So how does the current treatment of carried interest NOT change regular income into capital gains?

Note that this favorable treatment is only possible because the fund manager is not just the manager of the fund but is also deemed a 'partner' for tax purposes. This is done because one has to be a 'partner' in order to characterize payments as distributions and thus eligible for the lower tax rate. But note the fund manager almost NEVER puts up a signficant portion of the overall cash invested in the fund, he puts up a token amount and primarily in order to be deemed a 'partner' (putting up money does help convince the other partners that the fund manager is also 'invested' in the project but that is by far a secondary purpose).

Here's the way it should work. Profits distributed pro-rata to a partner's capital investment get the favorable treatment. Any distributions that are in excess of that are treated as compensation. Thus, if a fund manager puts up 10% of the equity, but per the partnership agreement, he gets a 20% cut of profits, then 1/2 of his cut is capital gains and 1/2 of his cut is salary.

It ain't complicated folks, no matter how the defenders try to paint it as such.