Carried interest is fair tax law for all investors

September 22, 2015 | By: Robert A. Green, CPA

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Carried interest is long-standing tax law that benefits investment managers and investors alike. Historically, carried interest contributed to the growth of the investment management, private equity, real estate and energy industries, and it’s had a positive effect on the overall economy and increasing tax revenues. Carried interest treats all partners the same. It is fair and not withstanding populist politics, the established partnership tax law should be maintained.

If Congress repeals carried interest provisions in investment partnerships, investors will be stuck with large investment expense itemized deductions that generate few tax deductions. There’s the 2% AGI threshold, Pease itemized deduction limitation and non-deductibility for AMT, the nasty second tax regime. Currently, investors have a reduction of capital gains as a share (carried interest) is allocated to the investment manager, which translates to full tax deductibility for investors.

A repeal of carried interest for investment managers will likely lead to the disuse of it in investment operating agreements for investors, which will put a chill on growth in the investment management, private equity and other investment-related industries. That will slow down the economy, choke finance of start-up companies and impair restructuring transactions. In other words, it’s the classic tax-hike/choke-growth policy which reduces tax revenues.

Investment managers are partners too, and they should be treated equally with other partners, the investors. Equal treatment ensures common goals and outcomes. This is, in fact, what happens with carried interest provisions. If investors receive a long-term capital gain, so does the investment manager who’s taking a risk in the transaction. Many pundits and Democratic presidential contender Hillary Clinton are calling for more long-term investment goals with related fiscal incentives. Clinton proposed stretching out long-term capital gain holding periods with graduated long-term capital gain tax rates. Why repeal carried interest, which is this fiscal incentive for investment managers to make more longer-term investments? Investment managers control the underlying transactions; not the investors.

Playing politics
President Obama and Congressional Democrats are campaigning to repeal carried interest; they claim it only benefits rich hedge fund managers and private equity executives, arguing they don’t pay their fair share.

Republican presidential candidate Donald Trump got on the populist bandwagon, riding shotgun probably so he isn’t pigeonholed by voters into the same corner as private-equity-rich-guy Mitt Romney who lost the last presidential election partially due to class warfare issues. It’s funny that Trump probably built a portion of his fortune from receiving carried-interest tax breaks in his real-estate syndication partnerships years ago.

When President Obama called for repeal of carried interest for investment managers in his two presidential campaigns and annual budget proposals, Senator Chuck Schumer (D-NY) objected, saying it singled out the finance industry (hedge funds and private equity) which obviously were concentrated in his state and New York City. Senator Schumer argued that carried-interest tax breaks were used in other industries — including oil and gas and real estate — all around the country, and if repealed, it should be repealed everywhere in all industries.

There are similar tax breaks throughout American industry in areas such as start-ups and tech companies. Companies grant stock options to executives and many executives benefit from lower long-term capital gains after exercising the options (the gain on option exercise is ordinary income). Companies use restricted stock units (RSUs) as another form of executive compensation, and they grant shares for sweat equity, too. How are these pervasive practices much different from carried-interest provisions in the investment management and private equity industries? As Senator Schumer argued, why single out and penalize investment managers and (I argue) investors, too?

The energy industry receives many special tax breaks including master limited partnerships (MLPs) and overly generous depletion allowances which some argue are phantom tax deductions. The real estate industry gets many special tax breaks with REITS and real estate partnerships with carried-interest provisions.

A call for the repeal of carried-interest on investment managers and private equity reminds me of another progressive-Democrat tax proposal for a financial-transaction tax (FTT) — a “small tax” on each purchase or sale transaction in financial markets. (Eleven EU countries are trying to adopt a version of FTT in the EU.) The FTT proposal is another populist attack to win over voters and while the intended targets are rich Wall Street institutions, FTT falls mostly on investors and retirees all around the country. FTT will also put out of business market makers and traders, which will significantly decrease liquidity and cause flash crashes more often. Even President Obama recognized that and it’s the reason why he prefers a tax on financial institution liabilities over a FTT on investors.

Politically motivated populist attacks are a dangerous game. Often a populist attempts to stab his target with a pitchfork, only to miss and stab his constituents in the foot.

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