Carried Interest Tax

The majority of the commercial real estate community is vehemently opposed to ongoing proposals to treat carried interest (see Mitt Romney's tax return) as ordinary income. Increasing the tax rate on carried interest from 15% to the applicable marginal rate will create significant challenges for hedge funds, pe shops, and yes, real estate investors.

For those of you on the investment side of the industry:
- How much does this worry you?
- How significantly do you think your comp will be affected?

For those of you looking to move into real estate investing:
- Would this tax increase deter you from pursing a career in RE investment?

And for everyone (this could get interesting)
- IS CARRIED INTEREST ORDINARY INCOME OR NOT?

 

I'm in PE, not real estate, but this affects me all the same. The answer is, it will affect compensation A LOT. Carried interest is a very significant part of a senior investment professionals compensation. Going from a 15% tax rate to a 40+% tax rate is incredibly painful. That said -- no one receiving carried interest is going hungry any time soon, so I'm not that worried about it.

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My opinion -- tax on carry should absolutely be increased for investment professionals that enjoy compensation in the form of carry. In PE, carry is paid out as part of a compensation package; therefore, it should be taxed as compensation...BUT carried interest tax rate should not be increased for investors.

Man made money, money never made the man
 
RE Capital Markets:
My opinion -- tax on carry should absolutely be increased for investment professionals that enjoy compensation in the form of carry. In PE, carry is paid out as part of a compensation package; therefore, it should be taxed as compensation...BUT carried interest tax rate should not be increased for investors.
I don't understand the distinction between investment professionals and investors (i assume you mean LPs)? Investors (LPs) don't receive their income as a "Carried Interest" and how they get taxed depends on the structure (how much can you reduce taxable income via depreciation, interest deductibility, etc...) and their status (whether or not they are tax exempt institutions, etc...).

Are you suggesting that Carried Interest be taxed as ordinary income or are you suggesting that there should be a special carried interest tax, or alternatively that capital gains taxe rates should be increased? Conceptually, I don't see how one can treat carried interest differently from, say, stock options given to entrepreneurs. Either they are both capital gains, or they are both ordinary income. Thoughts?

 
Relinquis:
RE Capital Markets:
My opinion -- tax on carry should absolutely be increased for investment professionals that enjoy compensation in the form of carry. In PE, carry is paid out as part of a compensation package; therefore, it should be taxed as compensation...BUT carried interest tax rate should not be increased for investors.
I don't understand the distinction between investment professionals and investors (i assume you mean LPs)? Investors (LPs) don't receive their income as a "Carried Interest" and how they get taxed depends on the structure (how much can you reduce taxable income via depreciation, interest deductibility, etc...) and their status (whether or not they are tax exempt institutions, etc...).

Are you suggesting that Carried Interest be taxed as ordinary income or are you suggesting that there should be a special carried interest tax, or alternatively that capital gains taxe rates should be increased? Conceptually, I don't see how one can treat carried interest differently from, say, stock options given to entrepreneurs. Either they are both capital gains, or they are both ordinary income. Thoughts?

I am drawing a distinction between true capital gains and carried interest paid to the GP. Carry is essentially a fee based on performance paid by the LP to the GP for services rendered and (by definition) not capital gains. When fund level capital gains are distributed to the GP, those profits are no longer capital gains, it becomes ordinary income for the GP and should be taxed as such. Arguing that this is not the case is complete nonsense - it is what it is.

Here is where it gets sketchy - after fund level capital gains are taxed, should the profits distributed to the GP be taxed again as ordinary income? I say NO and the tax rate applied to fund level capital gains should be bifurcated between capital gains distributed to the LP and fund profits to the GP should be bifurcated again between carry (perfomance fee paid by the LP to the GP, taxed as ordinary income) and capital gains (from the GP's investment into the fund, if applicable, taxed as capital gains).

I also don't see the issue as binary in nature - either taxing capital gains as capital gains or increasing the capital gains tax rate to ordinary income rate. This is a complex situation that deserves a complex solution.

Bottom line - the GP should not realize capital gains tax rate UNLESS the GP invests its own assets into the fund.

Man made money, money never made the man
 

Compensation of employees is always driven by compensation of the competitive set. For an acquisitions associate at a large private equity fund that likes to hire former investment banking analysts, that means compensation will largely be driven by i-banking analyst/associate compensation, which is indifferent to carried interest taxation. So in the short-run, as a relatively junior employee paid in salary and cash bonus, I can't see a change in the tax policy affecting me much.

The carried interest tax will hugely affect the net after-tax pay of senior level professionals with stakes in the general partner, which could ultimately affect me in the long run. I am very curious, though, how our brilliantly insightful Congress will go about writing such a law. How will they define a "disproportionate share of profit"? I think they will ultimately find it quite difficult to legally differentiate between profit paid as compensation for work and profit paid as compensation for accepting greater risk.

 

P.S. It's also laughable that most of the theoretical versions of this tax amendment that have been bandied about stipulate that "venture capital" funds will be exempted from an increase in the carried interest tax. As if somehow the development of the next Angry Birds is of greater national interest and needs greater tax incentives than, say, building highrises or restructuring struggling businesses.

 
re-ib-ny:
P.S. It's also laughable that most of the theoretical versions of this tax amendment that have been bandied about stipulate that "venture capital" funds will be exempted from an increase in the carried interest tax. As if somehow the development of the next Angry Birds is of greater national interest and needs greater tax incentives than, say, building highrises or restructuring struggling businesses.

As with all things in politics, one only need to follow the money to find the answer to this one. VC firms are almost invariably democrats many whom are also gung-ho about all the greentech stuff that democrats have been supporting-- Vinod Khosla claims to be a free market Republican but he is also huge on the green and ethanol scene. Their money and resources have been pouring into these pet causes.

The PE industry also leans democrat in general but they are much more useful politically right now to be used as pinatas and boogeyman to be smacked around.

Having said that, I believe the preferential carried interest tax has a much better chance of surviving if Obama is re-elected than Romney.

Too late for second-guessing Too late to go back to sleep.
 
brandon st randy:
Having said that, I believe the preferential carried interest tax has a much better chance of surviving if Obama is re-elected than Romney.

Can you please explain your rationale on this? I would think the opposite because... 1. Obama will continue to make sure top earners (i.e. PE MDs receiving carry), pay their "fair share." 2. If Romney were to push for carried interest to be taxed more heavily, it makes him look like a hypocrite. His exploitation of the current carried interest tax is very public to anyone who has picked up a newspaper in the past year. Why would he come out and say "hey guys, its really screwed up that I have been making straight bank off of this tax structure. Lets change this." Just doesn't seem like a smart political move.

 

@ re-ib-ny - based on my training and reading in/of economics, your points get at why I'm deeply sympathetic to economists who declare that taxation should be vastly simplified. Defining all increases in wealth under a blanket of "income" would allow taxation under an umbrella of some staggered burdens (5,10,20% ladder, etc. on all income, and do away with capital gains taxes), which is stupidly simple and far better than most people would intuitively think (especially if you're worried about mitigating the danger of political power). Couple that with sales taxes and Pigou taxes and we're thousands of miles ahead of where we are now in terms of efficiency... but people are too stupid and/or corrupt to move in this direction.

 

I think you're a bit confused about carried interest. Carried interest is currently taxed at the capital gains rate, regardless of whether it is a short term gain or long term gain.

Those gains are only taxed when the gain is realized; in your example, ESL will not be taxed if Sears appreciates, only if they sell and realize the gain. Then, the General Partner in the fund, in this case Lampert, takes 20%. This 20% gain will be taxed at the capital gains rate. His share does not increase, instead, every partner's share grows larger.

The tax that is constantly being discussed refers to the carried interest (the 20%) asset managers will take. When the GP of the fund receives the profit after the gain has been realized, capital gains taxes are levied. With the new tax laws, this carried interest is taxed as regular income for the GP's (in your example, Lampert)

 

It's very hard for me to view carry as more similar to ordinary income than a capital gain. It looks and smells a lot more like an investment than wages or salary. Whether it should be taxed or not is another argument, but calling it ordinary income is just not correct IMO. Will be interesting to see how this one plays out. Given our country's addiction to running deficits, I do feel like this one is going to be pushed through.

NAIOP has a pretty good summary of their position, which I think many in the industry share. http://www.naiop.org/governmentaffairs/issues/carriedinterest.cfm

 

I haven't read the document... Yet.

I'm in real estate private equity. We use the same 2 & 20 model that corporate private equity firms use.

I can understand the argument of the 2% being taxed as ordinary income (revenue actually), but not the 20% as we hold the investments for more than a couple of years and this fee is contingent on the gain in the investment.

The 20% for us is not ordinary income. It's more like our share of the investment or an option on the increase in value in the asset. Sometimes management get similar kind of stock options to get them to stay on post acquisition... is this carried interest also?

The only intelligent argument I've seen for the 20% to be taxed as ordinary income is if you considered it as an option and then taxed the option value granted. How you would go about calculating what the option is worth in order to tax it, and how would you tax it? Would it be when granted, i.e. at the time of an acquisition/investment, or when it is exercised. I can't see how you would do the former without causing phantom income/tax issues for GPs.

Ultimately taxes in the USA (in particular) tend to be less principle based (i.e. have a rationale) and more driven by the accumulation of rules / politics of the time.

There was an intelligent discussion on this a while ago where we took turns playing devil's advocate for each position. I wish Romney would have pulled out of the race so this wouldn't be such a politicised issue.

I wonder if they have proposed any changes for FIRPTA and such. Could affect FDI. The UK is so much more attractive for our co-investors than the US is as it currently stands.

 
Relinquis:
I can understand the argument of the 2% being taxed as ordinary income (revenue actually), but not the 20% as we hold the investments for more than a couple of years and this fee is contingent on the gain in the investment.

The 20% for us is not ordinary income. It's more like our share of the investment or an option on the increase in value in the asset. Sometimes management get similar kind of stock options to get them to stay on post acquisition... is this carried interest also?

Unless it's your money you're investing you never earned it and therefore never paid income tax on it to being with. Why should the performance fee (i.e. bonus for doing a good job managing other people's money) not be taxed as ordinary income?

 

I agree with you CS Arb - it's not their money so it should be salary. It doesn't matter that its "realized" when a transaction closes a few years later.

I also disagree with the OP's statement that this proposal is one of the more interesting parts - it's not. It's been talked about for a while and its only common sense. We either drastically reduce the size of government Ron Paul style so that we can afford the low tax rates for everyone or everyone will need to pay a higher rate, including the HFs.

It's not an issue of theory - the only reason the industry doesn't see it as regular income is because it shrinks their wallet.

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Best Response

CS Arb, how are (should) incentive stock options taxed? What happens after they are exercised ,i.e. do you tax the increase in value of your share of stock after the option is exercised as capital gain or ordinary income assuming that the grant of the stock was already taxed? How do you tax the grant of the incentive stock option when there is no readily ascertainable market value?

From my point of view when you make an acquisition where you have contractual carried interest you have basically exercised an option at the time of grant. I can understand wanting to tax the grant of the option to earn carried interest as ordinary income, but not the subsequent increase in value as it is most certainly capital gains for the kind of deals that I mentioned earlier. The issue of how you would tax the carried interest at T0 arises? What is its value? It certainly isn't the NPV of the carried interest as you don't know how the deal would perform, if there would be any carried interest at all. These aren't market traded options. The proposal of taxing carried interest as ordinary income doesn't recognise that you are making an investment in the asset.

Depending on how the laws change, I can see the business go to a model where you issue a ton of various kinds of stock options, warrants, and such to the PE firm/sponsors at the time of acquisition. This will still cause some phantom tax issues.

 

Relinquis are you saying that just because the value is hard to calculate at T0 we should just treat it as equity?

That makes no sense. A higher tax rate doesn't change anything.

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Relinquis: If I'm not mistaken, bonus stock options are taxed at the amount they're worth to you at the time they are exercised. If you exercise the whole bunch for a total value of $X worth of stock at a total strike price of $Y, then you essentially add $(X-Y) to your year's income.

Why bother futzing about with T0 anyway? Just tax the entire thing at the time of liquidation. No need to mess with valuing the firm or keeping track of its worth every year.

 

KarateBoy. No I'm not saying that (read my post). It is an issue though.

Angus Macgyver, that's not necessarily the case for incentive stock options (ISOs). The grant of the options isn't taxable, the exercise isn't taxable and the sale of the stock is taxed as capital gains if the stock is sold: - 2 years after the ISO is granted, or
- 1 year after the ISO is exercised This kind of stock is limited to 100k or so.

There are other forms of stock option (NSOs) Non Qualified Incentive Stock Options, where like ISOs, there is no income recognition upon grant, but unlike ISOs, there is income recognition upon exercise. The increase in the stock price post exercise is also treated as capital gains as long as the two conditions above are satisfied.

Why should carried interest receive less favourable taxation than NSO? It doesn't make sense. I can understand wanting to tax carried interest when it is granted (there will be major phantom tax issues) but the value would be minimal as it would be T0. So what value would you tax at that time? To say that the increase in value and the carried interest amounts paid in later years aren't capital gains just doesn't reflect reality.

I'm talking specifically about PE and REPE as our investments are long term. When I close an acquisitions I haven't made any money yet (apart from the management fees). My returns are pretty much entirely dependent on the increase in value over the hold period (capital gains). If you want to tax my option on this capital gain (which by definition i exercise at T0 for a price of 0) then let me know how you are going to value it when there is no market. Are you going to treat it the way VCs & entrepreneurs stock options get treated?

Most likely if the plans are put in place, you'll see a ton of NSOs and warrants issued by PE firms.

 

Yeah, I think incentive options should be taxed as ordinary income as well so that argument really doesn't work with me. Not saying I'm right but that's my opinion. It's just differed comp, sure there is an investment component but there's an investment component implicated in most bonuses in finance (just ask anyone on the sell side this year).

 

CS Arb,

Investment component in sell side finance jobs? ... Anyway...

What do you think of this scenario? If I was awarded straight equity as compensation for originating a deal for a client/investor (just ordinary common shares equivalent of 1% of the deal, nothing fancy). We exit the investment 5 years later at a profit.

Do you think I should be taxed at the time of being awarded the equity as ordinary income and at the time of exit in 5 years also at ordinary income, or should the exit be taxed as capital gains?

 

Relinquis why do you keep bring up the idea of being taxed "at the time of being awarded the equity"?

U.S. Tax code is based on realization of cash - there are no accruals to worry about. If and when you get cash, that's when you pay taxes.

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CS Arb,

so if in the scenario i outlined instead of being awarded sweat equity/common equity, I was given a cash fee and then reinvested the cash in the company, would I pay ordinary income at exit in year 5 or capital gains?

KarateBoy, with NSOs don't you get taxed when you exercise options? This makes the remaining "investment" in the company taxed at capital gains. This is a similar concept to granting a carried interest at the time of an acquisition and the actual cash returns later... the issue is that people confuse awarding the carried interest (which is equivalent to exercising an option) with the returns on investment which should be treated as capital gains (this is a separate discussion from whether capital gains and ordinary income should be taxed the same. I think they should, but that's not what we are discussing here).

There is a similar treatment of restricted stock...

 

If your company gave you the cash and you chose to invest it in a real estate deal you should be taxed at ordinary income on the cash you receive and capital gains in 5 years on any capital appreciation on the real estate deal. And if the investment goes down then you still would have paid ordinary income on day 0 and have a capital loss to offset any gains you have in year 5.

Similarly, If you run a hedge fund and receive cash from a 20% performance fee at the end of the year and choose to reinvest this cash back into your fund you should be taxed at an ordinary income rate on that 20% and then at the capital gains rate on anything you reinvest back into the fund.

 
<span class=keyword_link><a href=//www.wallstreetoasis.com/company/credit-suisse>CS</a></span> Arb:
If your company gave you the cash and you chose to invest it in a real estate deal you should be taxed at ordinary income on the cash you receive and capital gains in 5 years on any capital appreciation on the real estate deal. And if the investment goes down then you still would have paid ordinary income on day 0 and have a capital loss to offset any gains you have in year 5.

If you run a hedge fund and receive cash from a 20% performance fee at the end of the year and choose to reinvest this cash back into your fund you should be taxed at an ordinary income rate on that 20% and then at the capital gains rate on anything you reinvest back into the fund.

How is that different from getting paid with common stock instead of cash? In that case you said I should pay ordinary income tax on the gains in investment value. Do you get the point I'm making? The year 5 exit value is not deferred compensation, rather return on investment.

 

No, I don't think we are understanding one another. You don't have the option to get paid anything when you originate the deal because it hasn't preformed. You get paid a performance fee (aka bonus) when the PE deal / fund does well. If it doesn't do well you don't get your 20% fee. If someone were actually willing to pay you on day 0 regardless of if the deal/fund preformed well then you should treat that as ordinary income and if you reinvest it into the fund then the appreciation should be capital gains. The problem with your hypothetical is that there is nothing on day zero because no one is going to pay you a performance fee on something you haven't done yet. It gets back to the point that the 20% in 2/20% is an incentive not an investment. Your job happens to be investing so smart lawyer/lobbyists have fooled idiots in Washington into thinking that if your job is investing your income is investing which it isn't.

 

CS, i'm talking from the perspective of the GP, not as an employee who gets a salary and bonus from his employer. A GP's performance fee is not a "bonus" at all. I think this is where we are losing one another. Maybe things are structured differently in the HF world.

In the example where I highlighted getting paid common equity instead of a cash fee of 1% of the deal size and reinvesting that in the deal, it absolutely make sense. From the client/investors point of view in that scenario the only difference is that they don't have to fund the 1% in cash, rather in dilution. The scenarios are equivalent and they should be treated the same.

The carried interest concept is "similar" to the one above except that it is complicated by having a contingent element (hurdle rate) to receiving the initial notional 20% of equity. So it acts as an option. The returns on the notional 20% of equity are capital gains, not deferred compensation or some other type of ordinary income... I'm probably making my point less clear by putting it this way.

 

It's contingent because it's a bonus/compensation not an investment. I think that's the point we disagree on. You view it as having earned the money on day one, if that was the case there would be no hurdle rate and you could collect the money regardless of performance. This isn't the case, you can only collect the 20% fee if you do your job well which is why I view it as compensation (in the form of a bonus) not as an investment (your job just happens to be investing). It's not an option it's a bonus for performing your job well.

 
KarateBoy:
Doesn't Renaissance Technology charge something crazy like 3/30?

EDIT: http://www.insidermonkey.com/blog/2010/12/30/best-hedge-funds-jim-simon…-alpha/

I think CS said it best - just because you work with investment doesn't mean that you are earning investment income.

I would even pay much more than that - to be in the Medallion Fund haha

 

What is the 20%? I think it is qualitatively different from just a commission or fee for service (see below)...

The way I see it there are two components of the 20% (conceptually): A - 20% of the equity, i.e. the 20% catch up that gets you to an imputed 20% share of the company's initial investment. B - The return on "A", i.e. your pro-rata share of the capital gain given your 20% imputed equity.

I can see how "A" could be ordinary income (even when it is contingent on a hurdle rate)... you earn it by virtue of doing the deal, but I have yet to see a convincing argument for how "B" is not capital gains or investment income.

FYI, 2 & 20 isn't going anywhere in PE / REPE. If tax laws are changed to make "carried interest" taxed as ordinary income, we'll just charge 2 & a ton of (at the money, or out of the money) options or restricted shares (those get taxed as capital gains).

 
Relinquis:
What is the 20%? I think it is qualitatively different from just a commission or fee for service (see below)...

The way I see it there are two components of the 20% (conceptually): A - 20% of the equity, i.e. the 20% catch up that gets you to an imputed 20% share of the company's initial investment. B - The return on "A", i.e. your pro-rata share of the capital gain given your 20% imputed equity.

I can see how "A" could be ordinary income (even when it is contingent on a hurdle rate)... you earn it by virtue of doing the deal, but I have yet to see a convincing argument for how "B" is not capital gains or investment income.

FYI, 2 & 20 isn't going anywhere in PE / REPE. If tax laws are changed to make "carried interest" taxed as ordinary income, we'll just charge 2 & a ton of (at the money, or out of the money) options or restricted shares (those get taxed as capital gains).

So you think, conceptually, an LP gives 20% of his investment (cash) to the GP-which is then converted into equity when an investment is made?

Under that frame work - I think that's as much of an equity investment by the GP as it it as gift by the LP. If an LP gave a cash "gift", he would need to pay tax on it as if it was ordinary income. Try to sell that to an investor.

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Relinquis:
What is the 20%? I think it is qualitatively different from just a commission or fee for service (see below)...

The 20% is a bonus for performing well, it's not equity. Again this is where our difference of opinion stems from.

Who's to say that options and restricted shares in the manner you are describing won't be taxed as ordinary income?

 
What is the 20%? I think it is qualitatively different from just a commission or fee for service (see below)... The way I see it there are two components of the 20% (conceptually): A - 20% of the equity, i.e. the 20% catch up that gets you to an imputed 20% share of the company's initial investment. B - The return on "A", i.e. your pro-rata share of the capital gain given your 20% imputed equity. I can see how "A" could be ordinary income (even when it is contingent on a hurdle rate)... you earn it by virtue of doing the deal, but I have yet to see a convincing argument for how "B" is not capital gains or investment income. FYI, 2 & 20 isn't going anywhere in PE / REPE. If tax laws are changed to make "carried interest" taxed as ordinary income, we'll just charge 2 & a ton of (at the money, or out of the money) options or restricted shares (those get taxed as capital gains).
The problem is that "A" doesn't exist. At all. You don't contribute any equity initially so you'd "have to make it up".

If you were going to do as you described. There would be the initial taxation for part A, and then any appreciation. That would be taxed at the wage rate plus the capital gains rate.

2010: $1,000,000 in RE (nothing fronted by the fund) 2020: $2,000,000 in RE

Here is how "phantom equity share" would probably be simulated: Fund gets 200K as per the 20%. Because there has only been 100% appreciation 100K will be taxed at the wage rate and 100K will be taxed at cap gains rate.

Lets say that 100K is at the top marginal rate of 35%, cap gains at 15%. So you are paying 50K in taxes on 200K in gains. This is more than you pay currently.

Oh, and you didn't front any capital. Yeah, fucking horseshit.

 
PetEng:
Oh, and you didn't front any capital. Yeah, fucking horseshit.

So rude. What angers you so much about our firm not fronting any capital? We don't work for free. LPs need to pay up to get access to our skills & ideas.

Would you feel it is as "horseshit" if we asked LPs to give us stock options or restricted stock and paid capital gains on that?

 

R,

I understand what you're saying so maybe I'm not being clear.

The LP doesn't give the GP anything until he performs. If the LP did give the GP cash, then the LP would need to pay taxes on the cash - and that clearly doesn't happen.

The GP should not be able to invest someone else money (which they likely already paid ordinary income taxes on) and then share in the "equity income." This should be tax evasion. The fee earned by the GP is an explicit performance fee. I don't understand why that isn't coming across any clearer?

"B" doesn't exist - there is no such thing as "imputed equity" There is no such thing as a trade between the LP and GP for "equity." It's a fee ON the gain of the LP's equity and not a gift OF equity.

How is what a PE/HF does any different then someone being a sales rep who can keep a % of his sales (a commission) for a job well done?

I HATE the fact that I don't keep a keep a penny of my labor until May 1 of each year but that's the law and everyone should have to follow the same laws.

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KarateBoy:
... How is what a PE/HF does any different then someone being a sales rep who can keep a % of his sales (a commission) for a job well done?

I HATE the fact that I don't keep a keep a penny of my labor until May 1 of each year but that's the law and everyone should have to follow the same laws.

That's not the point. It isn't labour. We don't make "that" part of our money from hard work, but rather from being "right" about our investment decisions/speculations.

We only use LPs money in this way because it is efficient from a tax point of view. The alternative is to get commitments from them and bring them in on a deal by deal basis as debt, preferred equity or give ourselves a bunch of stock options if carried interest becomes less tax efficient.

Either way, you're not going to see the industry pay ordinary income taxes on their investment returns... making capital gains and ordinary income taxes the same would go a long way to fairer system and would avoid scapegoating an industry and trying to convince people that capital gains are the same as commissions.

 
So rude. What angers you so much about our firm not fronting any capital? We don't work for free. LPs need to pay up to get access to our skills & ideas.
Ummm, "skill and ideas" should be taxed as wage income. Not at the capital gains rate. The respective rates are irrelevant - however, at the current rates it effectively means you pay less than others.
Would you feel it is as "horseshit" if we asked LPs to give us stock options or restricted stock and paid capital gains on that?
Of course not. However that "2/20" model goes out the window if they also have to pay non-equity initially. They're gonna lose 20% before they see a dime of returns? Right.
 
PetEng:
Would you feel it is as "horseshit" if we asked LPs to give us stock options or restricted stock and paid capital gains on that?
Of course not. However that "2/20" model goes out the window if they also have to pay non-equity initially. They're gonna lose 20% before they see a dime of returns? Right.

Not necessarily... I've seen different models around the world... Stock options... different classes of equity... bringing in investors as pref/mezz... even a merchant banking model where you warehouse the deal and mark the equity up to investors (kind of like bridge equity, but this is very capital intensive)... those models tend to screw LPs even more.

I can even see the bigger firms going public / raising more permanent capital and treating LPs as pref only. You'll always see an asymmetric return between the sponsors and the capital providers and it will usually be structured in a way that allows the sponsor to be taxed at the capital gains rate for as long as the capital gains rate is lower than the regular income rate.

If the rates were the same, we wouldn't have to worry about this stuff and I could focus on choosing what investments to make instead of how to turn capital into income into revenue into cost into debt into whatever so I'm not treated disadvantageously vis-a-vis another speculator.

 

I respectfully disagree with your point that it isn't "labor." I don't think that labor of the mind is any more or any no less virtuous than manual labor. But even if it was "different", I don't think that the fact that you get paid for being "right" should give you any special tax treatment. There is no reason to encourage increased HF/PE activity through the tax code.

If we take this discussion up to the 40,000 foot level -why should any industry get special tax treatment? If I'm paying 35% of my income on the sell-side (or as a janitor or sales rep) then so should a PE/HF GP.

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That's not the point. It isn't labour. We don't make "that" part of our money from hard work, but rather from being "right" about our investment decisions/speculations.
That is irrelevant. You didn't front capital.

You have no capital invested and therefore you don't get capital gains.

 
I don't want "special" treatment.. I just want to be treated like any other speculator or sponsor... Whether it is an entrepreneur, CEO, a REIT or HF/PE firm...
You don't provide capital. Therefore you shouldn't be taxed at the capital gains rate.

Any of the aforementioned groups that don't provide capital shouldn't get taxed at that rate of capital gains either.

 
Relinquis:
unrelated (well slightly related question)... do you guys think capital gains tax rates and ordinary income tax rates should be the same?

Yes, if only to keep our complicated mess of a tax-code simple. However, I also think Income tax should be zero, so...

Calling Ron Paul an isolationist is like calling your neighbor a hermit because he doesn't come over to your property and break your windows.
 
Relinquis:
unrelated (well slightly related question)... do you guys think capital gains tax rates and ordinary income tax rates should be the same?
No, for instance, I think any income tax should be 0, consumption should be taxed instead, with increased rates on luxurious purchases, 40% inheritance tax with no exemption ( to prevent high worth individuals from bequeathing stocks to their heirs, solely to avoid paying capital gains in full). Alexander Hamilton, one of your Founding Fathers, was a supporter of consumption taxes as well.
 

I like the simplicity of "income is income". I think there are a lot of losses to needless professionals due to the complexities of our taxation structure.

Who knows it seems like all the economists want lower capital gains taxes so I guess there is probably some logic there.

 

Personally, I think it should be taxed at capital gains rates, if at all. But then, I think taxes are too plentiful and too high in the US in general. High income taxes should mean that people shouldn't pay capital gains taxes at all, which for most people outside of hedge funds, become a double tax. As Newt Gingrich said, people were upset that Romney only paid 15 percent in taxes and thought his taxes should be raised. The reality is that people should be trying to elect someone who wants to lower their taxes down to 15 percent in general. The government wants to always tax people but people are paying too much in taxes. Why can't Washington work to reduce their spending so people can pay less in taxes? Why can't the Fed be placed under the Treasury and then we can have less spending on interest that we owe bankers that own the Fed?

 

Just read through this thread and it is incredibly interesting. I'd just like to throw something out there to correct a misunderstanding:

For many (all?) PE funds, in order to qualify for carried interest, the GPs (investors) are required to invest their own, personal, already taxed dollars into the fund. This amount is modest compared to the potential carried interest payout, but it is very meaningful for someone who is just getting carried interest for the first time.

CompBanker’s Career Guidance Services: https://www.rossettiadvisors.com/
 

I agree with above poster in re consumption taxes, no income taxes, no capital gain taxes. But I don't believe that to pass money to heirs, you should have to pay estate taxes. But then again, I'm sure some ppl would just as soon buy large amounts of life insurance (tax free proceeds) to pay the estate tax anyway so no harm done.

 
TraderDaily:
I agree with above poster in re consumption taxes, no income taxes, no capital gain taxes. But I don't believe that to pass money to heirs, you should have to pay estate taxes. But then again, I'm sure some ppl would just as soon buy large amounts of life insurance (tax free proceeds) to pay the estate tax anyway so no harm done.

Here's my argument - if you don't pay estate taxes, the rich get richer, and you end up with a generation with none of the work ethic, but all of the cash, while the new "innovators" are unable to access said cash and there goes the society.

But Rhaegar fought valiantly, Rhaegar fought nobly, Rhaegar fought bravely. And Rhaegar died.
 

RE Capital Markets, the definition of carried interest (as you suggest) is the disproportionate share of profit paid to the GP above the pro rata profit it would otherwise be entitled to based on its share of the overall investment. The proposals that would tax such carried interest at the ordinary income tax rate make precisely the distinction you fear is ignored (although I'm not sure, because you at times clearly delineate carry from capital gains, while other times you seem to refer to the whole thing as carry). I've never heard of a proposal that would unduly penalize the GP's pro rata profit at a disfavorable rate. In any case, such a poorly written law would be easily circumvented: the GP's members would simply invest their stake as LPs, eliminate the concept of carried interest, and structure an incentive fee. Simple.

Defining carried interest as disproportionate profit is, however, more complicated than it seems. What if the GP just creates a more junior partnership unit that is subordinated to the LP investment and takes a disproportionate split of the profit there? One could argue the disproportionate compensation is no longer for the "work," but rather for the added level of risk. Or what if the GP does what every other executive in corporate America does and takes compensation in the form of options? Those get taxed as ordinary income at the Black Scholes value when distributed. But if you grant them out of the money, there's little to no value. The exercise would then be treated as a capital gain, so you'd get to the same place. Finally, I'm curious how they end up defining a "venture capital" fund. Seems like there would be all sorts of ways to get a real estate development to fit into the "venture" box with some effort.

 

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CompBanker’s Career Guidance Services: https://www.rossettiadvisors.com/
 

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