Tax Debate: It’s Your Turn

A reader yesterday suggested that I’m on a “crusade” to change tax treatment of carried interest for private equity funds. I actually think it’s Congress that’s leading the charge – see the latest – but let’s accept the premise that my coverage has been favorably disposed to such a change. Now it’s your turn.

This is an open call for peHUB readers to explain what you think Congress should do about the tax treatment of carried interest, and why. Just send me an email.

I will run every single response, with particularly good ones getting separate posts in Vox Populi. I also will forward the lot of them to the U.S. Senate Finance Committee. The goal is to get a comprehensive sense of how the industry feels on this extremely important issue. Divisions already have sprouted in the UK – Nicholas Ferguson’s lament that he pays a lower tax rate than his cleaning lady, for example – but we’ve heard precious little from a U.S. audience.

So please send me an email with your thoughts. My regular policty is to run only first names of feedbackers, but I would like as many “real names” as possible (only emails with real names will get submitted to Congress). If you are unwilling to use your full name, please indicate that in your email.

Let’s hear ya.

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124 Comments

  • Might also be worth forwarding them on to the UK Treasury as well Dan

  • Congress should do…nothing. Absolutely nothing. No hearings, no legislation. There is no evidence of a compelling need to do anything.

    PE firms only generate taxable carry by producing investment returns. This is wealth creation, which benefits the GPs, LPs, pensioners, and portfolio companies; government meddling will most certainly be to the detriment of all of these people.

    This entire episode is driven by pure greed. A group of noisy busybodies covet something that someone else earned, and they want to use the blunt force of the government to take it.

    No one is forcing LPs to invest in PE firms at these terms. If anyone thinks PE fee structures are outrageous, they should open a competing GP with a different fee structure, and convince LP investors that they are a superior place to put their money. It’s the free market, the American way.

  • I think the treatment of carried interest should be the same as ordinary income. Personally, I am not sure how it could have ever been justified as anything but ordinary income.

    You are not making this money via investment of your own money. You are making this money via investment of other peoples money, as a function of one direct responsibility to their employer, the PE Firm itself.

    This carried interest, does directly reflect performance at ones occupation, and is directly coming form the work one does everyday. If there was never any such thing as management fees, these carried interests would be the primary income and it would obviously be taxed at the ordinary income rate. So PE funds charge double for the management of their money, one by standard fees, one by performance related fees (it is a fee, regardless of what it is called), and by charging double they get the benefit of less taxation?

    The worst part is that so called educated people think they can actually justify this treatment of carried interest. Don’t get me wrong, I would be happy to accept it if I were on the receiving end of this beneficial treatment, but I would have enough slef respect and moral responsibility to understand how ridiculous it is, and would not open mouth to justify and still consider myself a good or intelligent person.

    This income is obviously generated from one’s profession, and should be taxed just as any salary or performance bonus would be taxed. Just because the way we are doing it is worng, doesn’t mean intelligent people have to stop to such a low standard to endorse such an illogical concept.

  • I sat next to a US VC at the recent EVCA Symposium in Rome and we got to talking about the issue of taxation of carried interest.

    I was amazed at how egocentric he was on this issue. I can understand that many of my collegues would like to keep low taxation of carried interest.

    But I cannot understand how they can ethically defend it.

    1. Capital gains are earned on capital which you put at risk. You do not risk any assets in order to earn carried interest. So carried interest cannot be seen as capital gains! (Sure we are required to co-invest in funds, but we earn separate returns on that).

    2. Since it cannot be viewed as capital gains, then in can only be viewed as a performance-bonus and should be taxed as such. Ie. personal income.

    It is a complete and utter lack of morality to think that can defend that you should pay 10% in tax on your bonus, when the car salesman pays regular income tax on his bonus.

    I can understand that some in the industry fight this issue in order to retain their low taxation. But using arguments like “it is capital gains” is like shooting yourself in the foot. No regular person – not to mention politician – is going to understand how you get to that conclusion. This really risks undermining all the other good issues that the industry can point to.

    And it has absolutely nothing to do with socialism. Socialism is about the general level of taxation and about what progression you have in your tax system – not whether some people can work the tax rules to avoid paying tax.

  • First off, I’d like to let you know that I have enjoyed your daily missives. We’re not always in agreement, but you’re always informative or entertaining.

    Regarding taxation of carried interest, it seems that private equity carry consists of both a current income portion and a capital gains portion. The ordinary income basis for the fund should probably be imputed to be equal to the carry percent (i.e. 20% in most cases) of the initial investment. Since PE funds can’t take the money out at the time of investment, the ordinary income should be deferred until the liquidating event. Gains in excess of their imputed ordinary income basis should be taxed at a capital gains rate. It would also seem reasonable that the ordinary income basis established for each investment should be aggregated at a fund level so that investments that tank will lower the aggregated ordinary income basis. Dividends received by private equity funds in which they have control should lose their dividend characterization and be taxed based on the above method.

    That explanation is probably as clear as mud. It’s worth what you paid for it.

  • I think Ben Franklin would be in favor of a tax rate on Interest that is HIGHER than the rate on labor/wages. He saw the taking of Interest income as detrimental to the whole economy. The more you put a burden on others by taking interest gains, the more the government should tax you. Your readers might get a kick out of this quote:

    “Now the Interest of Money being high is prejudicial to a Country several Ways: It makes Land bear a low Price, because few Men will lay out their Money in Land, when they can make a much greater Profit by lending it out upon Interest: And much less will Men be inclined to venture their Money at Sea, when they can, without Risque or Hazard, have a great and certain Profit by keeping it at home; thus Trade is discouraged. And if in two Neighbouring Countries the Traders of one, by Reason of a greater Plenty of Money, can borrow it to trade with at a lower Rate than the Traders of the other, they will infallibly have the Advantage, and get the greatest Part of that Trade into their own Hands; For he that trades with Money he hath borrowed at 8 or 10 per cent cannot hold Market with him that borrows his Money at 6 or 4.”

    Ben was only a kid when he wrote that. However, he was clearly aware that interest itself, and people paying different interest rates, was causing a huge ripple in the economy, and that it would be best if the rate were low and consistent for everyone, so as to remove the incentive for engaging in “prejudicial” behaviors, ie, against the commongood. Of course, today China and Japan are the nations with the advantage of a lower rate, and they will eventually clean our clock if we do not become wiser than the past. I suspect that many of your readers will resist the obvious implication that their private gain is not to the public’s good. Afterall, that is what Scrooge told himself everynight when he went to bed, too.

    The mirror is a treacherous place, and nobody wants to come to terms with seeing their sins in the full light of day, which is what Scrooge experienced in his dreams. Fortunately, we can all be redeemed.

    The best way to avoid the tax is to avoid the sin. If it is bad to pay high interest rates, then it should be bad to take the profits from high interest rates. The Golden Rules applies to everything, including money. Since we are now graduating kids from college with lots of loan debt, we have pretty much become a society where the adults are devouring the young. (The young pay for the sins of the fathers.) More taxes, unfortunately, won’t solve this problem. If taxes could solve a problem, then the world’s problems would have been solved a long time ago. lol

  • I think that this is such a hot issue because low tax rates are enviable. I’d like to see someone in Congress propose lowering the tax rate for all other income rather than increasing it on carried interest.

  • Yes, fixing the carried interest issue is worthwhile, but REFORM of the entire US tax code makes more sense. Currently, the tax code is a Hodge Podge of changes with NO overall thought. Let’s get rid of AMT and stress the importance of low taxes on long term capital gains, among other matters.

    Eliminating corporate tax subsidies is more important.

    We all have our political views, but I read your column for the investment and business news. Note that today’s news says the Blackstone deal is a blowout, but because of foreign investors who may not ever pay US taxes.

  • I do not believe carried interest should be taxed at the 35% ordinary income tax rate. Portfolio companies pay taxes at a federal corporate rate of 35% (plus state taxes, FICA, etc). It is excessive to then charge an additional 35% on the profits made by the investors. The recent push to raise capital gains taxes on private equity investors has more to do with people upset by the wealth these professionals are creating for themselves than a sense of “fairness”.

    A real fix would be to simplify the tax code to prevent tax lawyers from trafficking clients’ money through our current swiss cheese tax regime. This proposed change does nothing more than add another layer to an already overly complex tax system. I would imagine high priced tax lawyers are already salivating over the fee potential.

  • From a venture capitalist’s perspective:

    Despite carried income’s façade of being a fee for a service, unlike those bonuses of investment bankers, a salesperson, or a real estate agent, a venture capitalist’s carry is inextricably linked to returns generated from long-term investments. This fact alone could suffice to keep legislation at status quo.

    On to the practical reasons that truly make this compelling. The United States has become a place where the pace of innovation is slowing compared to that of our foreign competitors. To combat immigration policies that currently quell innovation in our schools and enterprises, as well as labor costs that are prohibitively high, tax advantages for venture capitalists are warranted. Further, there is the clear case that almost every venture capital dollar invested adds jobs to an economy and a people that continues to struggle to compete with our lower-cost neighbors for precious wages. Lastly, and perhaps most practical, is the link to the taxes that the US government gains from keeping the legislation as-is.

    If carried income were to be treated like normal income, there would be a rush from limited partners’ to pull their investments from venture capital funds into other asset classes. This would put many would-be funds out of business before they begin. Certain assumptions can be made, and the numbers run, but the undeniable truth is that many funds that might otherwise generate 15% of its general partners’ carried income for the government would generate 0%, and $0. The government would make no money on these funds because they would never make a single investment.

    People are rational beings, and if tax laws discourage investments in the venture asset class, they will not be made. On the small group of top performing funds that manage to maintain a strong limited partner base there will be another shift in structure. The venture industry will become a more fee-driven business, and top firms will change their structure from the typical 2/20 to a 3/15, or a 5/10 structure.

    These inefficiencies will consolidate the venture industry, stem the tide of innovation, and cost Americans jobs.

  • I run a very small later stage fund that invests in growth and buyouts. As the length of time of exit in this segment has quadrupled in the last 4-5 years and LPs successfully inserting preferred returns in most partnership agreements, I will not receive my carried interest until the fund is probably more than 7 years old (and possibly as long as 9 or 10). What is not “long term” capital gain about that?

    Don’t penalize us all for the few that hit the headlines.

  • Carried interest should be taxed at 19%, as should all other income as part of a flat tax system.

    Since the federal government has historical confiscated somewhere in the 18-20% of national income regardless of the annual changes in the tax code, let’s just fix 19% as our flat rate for all income. This would save billions of dollars and hours spent doing taxes, make America much more efficient and competitive, and accelerate economic growth.

    If combined with elmination of corporate taxes (to avoid double taxation), the side benefit would be a far more effective cure for Washington corruption than any “campaign finance reform” because the tax code is such an attractive place for politicians and lobbyists to do their dirty work.

  • To argue that carried interest fees are not bonuses, but “capital gains” is just silly. To have capital gains, one must have invested some capital and the nominal 1% the GPs invest in their own funds does not count. Therefore, where is the capital on which the GPs have made their so-called “capital gains”?

    Furthermore, the argument that carried interest fees need to be taxed as capital gains because of the risks the GPs take is just nonsense. GPs DO NOT TAKE ANY RISKS¬they invest zero or nominal capital in their own funds, and take home VERY nice salaries based on management fees alone. Carried interest fees are performance bonuses, pure and simple, just like any other Wall Street performance bonus.

    I am a LP in several hedge and private equity funds. I am the one risking my hard-earned savings, not the GPs. When a fund tanks, I lose my capital¬GPs just lose their management fee income, so exactly who is the one risking their capital? If GPs’ carried interest fees are “capital gains,” then where are the corresponding capital losses for the GPs, when a fund tanks?

    Any true performance bonus is, by definition, is risky. The PE firms’ argument imply that every salesperson’s commission, every Wall Street trader’s annual bonus is “risky” and therefore deserving of a lower tax ate. I wonder what the IRS would think of that argument!

    I work as a business broker, and am only paid when I successfully sell my client’s company. My success fees are, in reality, far more risky than any hedge fund’s carried interest fees, and I often invest my own capital in the form of non-reimbursed expenses for a year or more, working on a deal, yet I cannot claim my income as capital gains.

    BTW, all this furor is just another argument for a simple flat tax, that treats ALL income the same way.

  • The entire discussion around LBO taxation changes perplexes me. After all, millions of Americans are doing LBOs all the time. As a matter of fact, much of the increase in the US standard of living over the last ten years is based on the LBO concept.

    You don’t understand what I mean? Ok, here we go:

    Let’s say you are buying a house for $400,000 that you plan to let to a tenant. Now, in many cases, you will not be able to afford to finance the entire transaction yourself, maybe you can contribute $100,000 to it. So you will get a mortgage over $300,000 to finance the remainder. Then you will buy the house ($400,000) with a portion of your own money ($100,000), plus the portion of borrowed money ($300,000). Subsequent to this, the tenant will then pay the mortgage payments via paying the rent (very nice!). Now let’s assume that you manage to sell the house after three years for $500,000 (an increase of 25% on the original price). You pay back the mortgage (let’s say $300,000 to keep it simple) and you end up with $200,000 in cash. So, within three years, you will have turned $100,000 of your own money into $200,000. This is twice the original money invested, at an IRR of ca. 26%.

    Brilliant, you are so good, you could be in private equity!

    Oh wait, aren’t you? After all, didn’t you just buy and sell a privately owned house with borrowed money with the intent of selling it afterwards to make a profit? How exactly was that transaction any different from an LBO? Isn’t this exactly the same?

  • It is interesting that the government and the press are targeting the private equity GP’s, primarily on three counts:

    - the size of their pay (lately – no one mentions 2002, 2003, 2004), and its associated tax treatment;
    - the risk to a target company’s pension fund, given the increased debt load post acquisition; and
    - the treatment of employees in LBO transactions.

    Starting in reverse order:

    - Private equity is capitalism at its best, increasing the general
    competitiveness and efficiencies of companies, industries, and their
    employees. If governments want a socialist system that protects inefficient companies and their employees, we should send the government’s representatives to Russia or China so that they can recall how well a socialist system really works. Wait that may back fire as both Russia and China have already thrown out socialism in favor of capitalism.

    - Fair comment, and probably the only real point to stand on, but then pension funds have always been at risk, as existing management teams and boards can lever up a company – in many cases they already do, and nothing is done – see all the airlines that have gone through a rash of chapter 11 protections.

    - Finally, the real reason for the increased attention, GP compensation. The reality is that no one really likes anyone else to make more money than themselves. Everyone wants you do well, but not better then themselves.

    What is interesting is that the private equity industry is in the light, whereas the hedge fund sector and its managers (a much higher compensated group) are not – maybe they already had their day in the limelight, and moved onto the offshore jurisdictions as a result.

    After spending a few days recently in each of Geneva and Zurich, it would not be hard to imagine many New York and London based private equity managers choosing to move their base of operations – not a difficult challenge when you have the means.

    Let the governments (UK and US), and press keep pushing – they would/will soon have very little to complain about, as the PE managers will all be outside of their domestic jurisdictions, and paying no domestic tax on their carries and/or the equity appreciation of the shares in their management companies.

    Could you imagine if Blackstone had been based in Switzerland or another low/no tax jurisdiction!!

    Keep up the great coverage, and don’t change your approach – its to the point, thoughtful, and thought provoking.

  • If Congress decides to change the treatment of tax on carried interest, then they should also change the tax treatment on incentive stock options. They are effectively similar forms of compensation.

    Let’s see how their constituents and corporate beneficiaries would feel about that.

  • For the record:

    - I do not receive a carried interest
    - For years I would have agreed that as a payment for services rendered, should be taxed as ordinary income

    As part of this debate, I gave the issue a little more thought and came to the conclusion that it should be taxed as capital gains for the simple reason that a carried interest is earned only on the profits of successful investments. It is a share of capital gains… not ordinary income. Ordinary income (interest earned on deposits for example) is ordinarily divided according to the share of actual dollars in.

    I suspect that most of the elected officials who have commented on this issue have done so dispite not understanding the structure of most private equity firms and the partnerships that they manage.

  • I’m totally confused about the debate. To me it’s clear that carry earned on investor capital is income, not capital gains. If these guys have any of their own money at risk and earn a long term profit, THAT is capital gains.

  • My proposition: Tax as capital gains the gains from non-controlling stakes of the fund, tax as income if the fund controls (and thus actively manages and operates) the asset.

  • You need to leave PE Week and write for “The Nation”. Without going in to the particulars, the tax laws are really a cookbook, with definitions being arbitrary and mutable, and as we are seeing, tempting Congress to confiscate property or coerce political contributions, at the expense of American productivity and competitiveness. Inside the Beltway (and in Massachusetts) no one has even the vaguest idea how jobs and wealth are created. These people actually believe that the Government creates wealth. I have my own issues with Private Equity, but ultimately, these buyouts eliminate fat and make companies more productive. As for VC, if it weren’t for venture capital, job growth would have been nil in the past 2 decades. If one is working for a carried interest, and the path to liquidity is 7 years, I can assure you that is not the came as current income. How, it is taxed is subject to the vagaries of Congressional whims. Give this subject a rest and write about something that we can actually do something about.

  • I am in an LBO fund and have carried interest.

    Carried interest is capital gains pure and simple. If there is no capital gain there is no carried interest.

    Think of it this way, an LP commits $10M and the GP turns it into $30M. Everyone agrees there is $20M capital gains here, yes?? Hard to say there isn’t. Thus the tax due is $4M (assume 20% rate)

    Now explain to me why, just because the LP has agreed to give 20% of this gain to the GP, the characteristic of this gain has changed into ordinary income and now the total tax due is $4.6M (20% on $16M and 35% on $4M)

    The argument that the GP does not have anything at risk is missing the point (at best), the reality is that there is $20M of capital gains.

    If the code is changed the lawyers will find a way around it via a new derivative instrument between the LPs and the GP. As a GP, I will buy an option from each LP for 20% of thier profits and I will pay them some nominal amount, maybe $1.00 each. I now have basis of $1.00 and anything in excess will be capital gains, just like a regular stock option, assuming my hold period is more than one year.

    Get over it people or if you are going to change this compensation method you better change the taxation on stock options as well.

  • One of the principle canons of capitalist economics is that reward is commensurate with risk. For that one reason alone – private equity firms have too little ‘skin in the game’– their carried interest in no way merits favorable capital gains tax treatment. But there’s more to it than that.

    Thanks largely to the reckless foreign policy of the Bush administration, our national government is deficit spending itself into insolvency. The U.S. social security and medicare safety nets are in serious jeopardy. Ours is one of the few countries in the industrialized world that does not provide medical care to its citizens. Every year our primary and secondary schools fall farther behind other nations. Even the Bush administration concedes that the income gap between rich and poor is widening.

    Against a backdrop of serious social and economic challenges, it borders on the silly for a privileged class to claim they should get a special tax break originally intended for those who actually risk the capital.

    The responsibility of our public servants is to promote the greatest good for the greatest number of our citizens, and the money recaptured from elimination of the special tax treatment of carried interest is desperately needed elsewhere.

  • I’m a reader from Japan and working at a private equity firm in Japan

    I’m not a U.S. tax payer who is at stake, but it does look natural for the tax authority to apply 35% personal income tax rate than 15% capital gain rate.

    We are taxed for the carried interests at 50%, highest bracket of the marginal personal income tax rate in Japan. It has been great to be treated as 15% in the U.S., but still the U.S. PE professionals are far better off than those who are doing the same job in the small islands of Far East.

    Carried interests are different from the actual investments where we put our actual money exposed to the risks. It’s a fee for success and the fee is income, naturally. PE professionals in the U.S. do not need any special treatments any more, because the industry is established and recognized, right?

  • The arguments here I’ve read for keeping taxes on carried interest status quo fall flat in my eyes.

    Jens,

    Your argument is flawed. In your “house LBO” example, the purchaser of the house puts up $100K of equity, therefore selling the house is a capital gain. Very different from a carried interest which has no cost basis, since its… a performance bonus and NOT a return on any investment.

    Troy,

    The argument that portfolio companies pay corporate taxes has nothing to do with the tax treatment a GP’s carried interest. Are you saying that a PM at Fidelity who invests LP’s money should only pay cap gains taxes on his performance bonus, since he invests in companies that pay corporate income taxes also?

    – Look, if I were making a ton of money and reaping the benefits from what appears to be a flawed tax treatment, I would grasp at anything that tried to justify my position. I wish you guys would quit ignoring the elephant in the room – you make a lot of money relative to the value you add, and at the end of the day the law probably won’t change b/c you’ll throw your money at the problem and lobby politicians who rely on your contributions to stay in office. As Don King once said, “Only in America”

  • Tim-

    Assume a wealthy individual has invested and then receives large capital gains (and pays the capital gains tax rate) on that investment. What happens when he dies and leaves that same money to his kids? Right, it’s an estate tax. The money is treated differently because the kid didn’t put it at risk and earn it via a capital gain. You can’t look at what the money is, you have to look at how each person received the money. You’ve had one of the better arguments but I still don’t think it holds up.

  • Fred –

    Your example doesn’t work because: 1. the original investor already PAID capital gains on 100% of his gains at the capital gains rate, end of disucssion. The estate tax is applied against post tax assets and is irrelevant to this issue, it is a totally different tax system.

    To expand on your example – how would you feel if you managed your wealthy fathers money and he agreed to give you 20% of the profits for doing this. Then you generate $20M in capital gains, why should the IRS get more than 20% of the total capital gains?

    I am still waiting for someone to explain to me why it makes sense that a $20M capital gain from my original example should be “reclassified” partially into ordinary income just because two independent, sophisticated investors have agreed to do this.

    People are getting hung up on the concept that the GP has nothing at risk, this is irrelevant since the LP DID risk capital, which resulted in a CAPITAL GAIN. No one can argue that this is not true. The real issue to argue is whether someone (an LP) can legally transfer capital gain to another person (the GP).

    It makes me laugh that people are trying to argue that the IRS should receive a tax windfall off what is 100% capital gain.

  • Jonathan has it right: the very simple solution is a flat-tax system in the United States. Not only would it eliminate so many of the problems and inequities (whether real or perceived) in our current tax regime that go well beyond the carried interest debate; it would also dramatically reduce the burden on our economy of the billions and billions spent every year on tax accountants and tax lawyers (who of course lobby hard for as complex a tax code as Congress can produce). And to the skeptics and naysayers who exclaim that the United States will never had a flat tax, I simply ask whether 20 years ago they ever thought that Russia would have a flat tax.

  • I used to work on the Hill in the 1990′s for a conservative Democratic Senator (who by the way, always wanted to lower the cap gain rate). I know that Seante and House staffers have really NO idea the hurt they will put on those entrepreneurs that have founded venture firms. A tax at ordinary income will certainly retard my consideration of whether or not I would raise a new fund–or do something much easier–like put my time and money into passive investments such as the stock market or a real estate transaction.

    Hmm….what is better for the U.S., innovation, technology advances, new companies and creating wealth…or having a fund manger decide its not worth raising another fund because of regulation and taxes? Staffers–tell your bosses to vote NO against tax increases–the vast vast majority of us are being lumped in with the media-starved managers who seek spotlight in the trade press.

  • I am sure that my comments are not new, but I believe that carried interest is nothing more than a bonus for performance. In which case it should be taxable at ordinary income rates, regardless of corporate structure. If the company is an LLC or S Corp. or other similar entity than the partners pay at the personal level. If it is a C Coproration than the company itself is liable. With that being said, if they invest thier own capital (money, not intellectual) into the equity of a transaction, than that investment shall be treated as capital gains, assuming they profit from their investment. If not, they can offset it or deduct at the rate of 3k per year like everybody else.

    On a final note, this is not a debate on US tax policy, this is about fixing an issue that the PE firms have been able to exploit. As a business owner, I am for lower taxes, at all levels and in fact our tax system needs totally changed. I personally believe that all retained earnings of any corporation should be tax exempt, since this is the only truly way to grow the economy.

  • I don’t know how many times I’ve said this, but I’ll chime in again for the cause. I’ll stay out of the politics because I really want to emphasize the point that this is what makes the most sense.

    The way to look at this is to look at where the money is coming from. Management fees are a payment made directly from LP’s to GP’s – ordinary income. Carried interest is derived from capital gains made on the principal that has been provided by LP’s on behalf of the GP. Essentially, the government should be charging ordinary income taxes on the notional principal amount upon which the total amount is based, and capital gains taxes on the remainder.

  • Ernie (and everyone in favor of taxing carried interest as ordinary income)

    So you think that all stock options should be taxed as ordinary income, correct??

    They are treated the same as carried interest right now.

  • Tim, good point but here’s my view, although I am not a tax person. If an individual has an exercisable stock option they have to actually purchase those securities, upon selling them they are then treated as a capital gain assuming they sell them one year after they purchase them. Although if this is not how the law works, and they are able to sell them immediately after they exercise, then as with any short term gain, it should be considered ordinary income.

    Also I do not think companies should be able to deduct stock options from net income. I do not see this as an expense, unless it comes directly from securites that the company has already purchased from the open market, i.e., maybe in the form of a stock buy back and then they issue them to an individual, that would be an expense. Not just authorizing new shares and then issuing them.

  • Ernie,

    In pre-ipo companies, stock options are typically priced extremely low, $0.05 per share, etc. They are priced low due to the nature of a start up company and the high risk that it will fail. The stock may be worth zero in the future. The options can be exercised for very little cash and the stock held for one year – then capital gains.

    In a PE firm, the carry when granted has no value since there are no gains yet. If the Fund was liquidated when the carry was granted, the GP would get zero. Also, if the fund is not successful the carry is worth nothing. This is exactly the same as with a stock option – if the company was liquidated immediately after the option or carry was granted, the owner of the option or carry would receive nothing. The GP’s carry could be purchased when granted at some low cost (i.e. $0.05) and this transaction would be identical to an option.

    Now over time the value of stock or carry will increase due to the work of the employee (in the case of a stock option) and due to the work of the GP (in the case of carry). Why is it ordinary income for the GP but capital gain for an employee?

  • Tim, Great Anology. But the employee is actually taking an equity investment, regardless of his or her’s basis. the GP (or their firm) is not.

    If the GP’s want capital gains treatment, then all they need to do is change the structure of their deals. Let the GP’s firm (whomever it may be) have equity options in the investments, just like your anology for the employee. Then it would be capital gains. but the LP’s will never agree to this, because it greatly dilutes their equity position from day one.

    But as they are currently structured, they should be ordinary income. Hence they are nothing more than performance bonuses on profits that the investors recieve from their investments, i.e., the fund that actually pays the carried interest out is deducting that as an expense, and the company that the GP’s own is collecting it as revenue, ordinary revenue.

    If you are an employee and earn a salary of 50k per year, and you are given a 50k performance bonuses (for whatever reason) I assure you that it is ordinary income. If you change the structure, then you could get it to the capital gain side. All of this just shows how complex and anti competitve our tax system truly is!

  • IMHO a 35% “ordinary” tax rate is damn-near confiscatory (the Church only asks 10%) and it’s peculiar that everyone treats it as an ordinary cost of doing business. If our tax rates were where they were when Ben Franklin was alive, it would be a non-issue!

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