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Memo to Congress: There are Legal Issues With Taxing Carried Interest as Ordinary Income
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The carried interest debate has kicked into high gear, with legislation currently under consideration that could tax carried interest as ordinary income. Much of the conversation relates to the incentives or disincentives this would create or whether it is advisable. On that front alone, our view is that it’s a bad idea. Risk takers and investors should be rewarded for creating value, and that behavior should be encouraged as much as possible. While treating carried interest as ordinary income may not kill the whole venture capital industry, it will cause some degree of contraction. Basic economics will tell you that some number of skilled people with other investment or career options will choose alternatives such as investing in the public markets over private equity if the disparity in tax treatment tips the scales for them. The tougher issue to resolve is the legal analysis of how this income should be characterized. The “capital gains” argument is essentially that carried interest relates to the split of the fund’s capital gains and should be treated that way. The “ordinary income” argument is that carried interest is really a salary formula for the fund’s managers based on the fund’s performance and should be characterized as compensation. Our view is that carried interest should be treated as capital gains. Here’s why: In a simple example, if a company or individual invests $100 and receives back $1000, most people would agree that the $900 gain is a capital gain. Now admittedly, if the company uses $100 of that $900 to pay salaries, the salaries would be ordinary compensation income to the individual recipients. But that isn’t the most accurate portrayal of what happens with a VC fund. The carried interest does not go to individuals as a performance bonus. It doesn’t immediately go to the individuals at all. Rather, it is just an agreed upon split among partners of the partnership’s gains. Partnerships are allowed to do this. The biggest problem from a legal analysis with this proposed legislation is how we would reconcile this with the way the tax laws treat other pass-through entities such as limited liability companies and non-VC/PE partnerships. If carried interest is deemed to be ordinary income because one of the partners gets a disproportionate share of the upside by contract, what will we do with other partnerships that do the same thing? For instance, if Bob and Tom form an LLC with the agreement that Bob will get some form of economic preferences or privileges (which happens all the time), will Congress want to treat any of the company’s capital gains that flow through as ordinary income to the extent they exceed Bob’s pro rata portion of the amount invested? If the answer is yes, this will often create a strong and irrational disincentive to investing through an entity because the aggregate tax bill for Bob and Tom is suddenly higher for no apparent reason. Such a scheme is also counter to the generally accepted principle that the investment characterization of a pass-through entity’s income should generally flow through to the owners without regard to preferences or privileges some owners may have over others. If the answer to this question is no (that Congress does not want Bob and Tom to have any of this hypothetical income treated as ordinary income as a result of Bob’s preferences), you have to question how it would be constitutional to tax VC and PE funds differently than other pass-through entities that effectively have the same legal form and the same or similar allocation and distribution schemes. This feels a lot like arbitrarily having different tax rates for identically situated entities, which you can’t do. If this legislation passes, I would hope and expect that it would get challenged in court. Paul Koenig is an attorney and co-founder/managing director of Shareholder Representative Services (www.shareholderrep.com), which serves as a professional shareholder representative following the acquisition of a VC-backed portfolio company. GET MORE VOX POPULI POSTS HERE
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December 15th, 2009 at 11:55 am
What a disappointment to read this after being promised a legal argument by the title. Like every other defense of the satus quo in this area, this argument begins by assuming its conclusion.
The fact is that, while ordinary partnership principles do allow some latitude in the sharing of partnership items, the tax trend has been in the opposite direction for the last twenty-five years or so. Tax lawyers make it their duty to carry every practical principle to its logical and unintended conclsuion. Like the tax shelter industry before it, the investment fund industry (with the tacit cooperation of the IRS and Congress, at least in their former configurations) has brought enhanced scrutiny upon itself by creating a system that is the reductio ad absurdium of an otherwise workable set of rules. By converting compensation income to capital gain, the current state of affairs simply has to distort economic behavior.
It is a fundamental premise of tax policy (at least since Stanley Surrey in the 1960s) that such distortive tax rules must be examined and evaluated as “tax expenditures”, i.e., subsidies (or penalties as the case may be) to private activity. It is a political decision whether the behavior in question should be subsidized, and evidently the political winds have changed. So far Congress and the IRS are content to allow returns to capital investment to be taxed at favorable rates under appropriate circumstances. It is a separate decision whether those who are compensated for assembling that capital and managing it on behalf of others should pay tax at those same favorable rates on the fruits of their labor.
As a political decision, this choice is beyond merely legal challenge.
December 15th, 2009 at 1:10 pm
In full agreement with Tommy Allen here …
The point of the lower capital gains tax rate is to incentivize the HOLDERS of capital to invest that capital in productive enterprise (private or public) rather than put it in a savings account or stuff it under the mattress. This is something that the government (and presumable the American taxpayer) has deemed important and beneficial to society and therefore worth incentivizing via a tax subsidy. The incentive is not for the “middle men” for lack of a better word.
In Private Equity, 99% of the dollars invested by the general partnership come from the limited partners. If the general partnership were taxed at a higher rate, the economics would not change at all for the limited partners. They would continue to receive EXACTLY the same amount of return as they did under the old system and thus they would have exactly the same incentive to invest their money as they did before. Therefore, there would be no change in the dollars invested in these vehicles.
You can make the argument, of course, that PE pros will make less take home money and thus the career path will be relatively less attractive. This is true but do we really care? It makes perfect sense that the government and America taxpayer would want to incentivize people with money to invest that money. But do the government and the American taxpayer really need to incentivize people to go into Private Equity as a career or is that just an unintended consequence of the tax law? Private Equity should compete will other fields for talent on the basis of economics, job satisfaction, etc. Does the government need to subsidize the economics portion of this equation? Probably not considering that PE will remain one of the highest paid professions around. We have an incentive where none is needed.
Tax policy as a whole should be “standard” with exceptions that are meant to incentivize certain behaviors (e.g. investing your own money, giving to charity, buying a house). So, if you are not truly being incentivized to do something differently that “we” deem important to society, you should be paying the ordinary tax rate – that is the default.
December 15th, 2009 at 1:42 pm
Steve has it exactly right. Paul has it exactly wrong. The point of the capital gains exemption (to the extent there is a point) is to get capital invested. It’s all about the supply of capital, not the guys who make a living investing it. Mutual fund managers get taxed at ordinary rates, and there seems to be no lack of smart folks clamoring to get into that business. The fact is that VCs and LBO guys get paid a ton of money, and a ton, even after taxes, is still a lot. And if 5, or 15, or even 50 guys decide to leave the profession because their tax rates went up, the profession will still exist.
December 15th, 2009 at 3:51 pm
Not sure I understand the comments. They all seem to still be arguing economic incentives and fairness points. My point had nothing to do with that. Rather, it was focused on a possible disparity in treatment of similarly situated pass-through entities if you start taxing only carried interest at ordinary rates but possibly not all other preferences, promotes, and similar terms in other non-VC partnership-type agreements. I’m not sure how you have a discussion about the proper treatment of carried interest without having a broader discussion of taxation of partnerships generally. If you want to tax carried interest as ordinary income (and I understand, but disagree with, the arguments as to why this might be desired), shouldn’t you do the same with any entity taxed as a partnership in which the partners/members/holders have a distribution scheme with similar preferences or differences in ratios of capital invested to distributions.
Here’s another example to hopefully illustrate this. A and B put equal money into an partnership P. P has cap gains and no ordinary income. For whatever reason, A and B agreed that A would get his money back first, then B, then a 10% preferred return to A, then a catch up to B, then 75% to A and 25% to B thereafter. Cap gains or ordinary income to A and B? If you want carried interest to be ordinary income, are you going to do the same with A?
December 15th, 2009 at 4:30 pm
[...] over peHUB. Not only is our fun and funny holiday card (embedded below) on the front page, but Paul Koenig’s article on taxing carried interest as ordinary income is top of the Vox Populi section and attracting some [...]
December 15th, 2009 at 11:31 pm
Paul, your article started with this statement: “Much of the conversation relates to the incentives or disincentives this would create or whether it is advisable. On that front alone, our view is that it’s a bad idea. Risk takers and investors should be rewarded for creating value, and that behavior should be encouraged as much as possible.” This is an argument about incentives (though I do understand that it wasn’t the main point of your article).
On that, I actually do believe there is a flaw that needs to be fixed (I am not a tax lawyer, so I will assume it works the way you have explained). Let’s take a really simple example of $25K being transferred between me and my sister.
In the first scenario, I give $25K to my sister tomorrow. she’ll be taxed on in at 35% (let’s assume I’ve already given her the tax free $12K this year and she is in the top bracket). That is pretty cut and dry.
BUT, according to your argument, if we had a “partnership” where she put in $5 (not $5K, just $5) and I put in $100K and that partnership generates $25K in “capital gains”, I could give her the entire $25K and she would only pay 15% capital gains. For $250 in legal fees I have just set up an LLP that saved us $5K in taxes. That is clear avoidance and should be completely illegal, if it isn’t already.
The preferential tax rate on capital gains should be reserved for value created by the capital invested PER INDIVIDUAL. Since a dollar is a dollar, it is impossible for your dollar to create more value than mine when invested in the same enterprise. Therefore, if the total pool of dollars generated a 10% return and you are being paid out at 20% you must have done something else for the additional 10%. Your capital generated a 10% return for you and you should pay cap gains on that. Something else (work, political connections, brotherly love, etc) generated the other 10%. Since that is not strictly related to capital, it sounds like ordinary income to me. Otherwise, you have an untaxed transfer of wealth going on between individuals which is discouraged in all other cases.
December 16th, 2009 at 4:21 pm
This is one of the lamest defenses of the egregious and unsupportable carried interest gift that was given to private equity hogs by Congress. The argument made in this article is completely devoid of any merit, and certainly is completely lacking in any legal basis or logic. The carried interest tax purports to tax labor as capital and as such violates every tenet of American tax law. It is also completely regressive and exacerbates the growing gap between rich and poor. There is no justification in law or equity for taxing the labor of a baker or teacher at a higher rate than that applied to a millionaire or billionaire. Shame on you for publishing such pablum!
December 16th, 2009 at 7:50 pm
I think it is funny that some of the comments here view a lower tax rate as an incentive to do anything. I’ll give you that it is less of a dis-incentive, but it certainly doesn’t incentivize me to do something. Also funny that somehow we are supposed to take comfort in this being a “political” issue rather than a legal one, when here I was thinking that law meant something, and politics was how people are elected.
Paul, ultimately I agree with your raising of a general discussion about tax treatment of pass through entities. Its a topic worth raising. For example, there are plenty of real estate partnerships with promotes, preferences, etc. Regardless of my view of the tax on carried interest debate, you raise a good question that will need to be addressed if things move forward.
December 20th, 2009 at 7:43 pm
[...] http://www.pehub.com/58106/memo-to-congress-there-are-legal-issues-with-taxing-carried-interest-as-o... [...]
December 21st, 2009 at 3:14 pm
Ignoring the legal, moral and incentive arguments posed by those of clearly differing political views, why not simply tax carried interest like an option? True, the proportional capital between GP / LP is skewed, and it’s difficult (at least to me) to argue either for or against it being a true “bonus.” It is obviously tied to performance, but bonuses can’t be taken back - carried interest can be taken back given clawback provisions in many LP Agreements.
Fundamentally, carried interest is more like an out-of-the-money option provided to GPs by LPs. If GPs make profitable fund investments over the lifespan of a fund, they get paid over a certain “exercise price” preferred return hurdle of X% compounded annually. If they don’t, it’s worthless and if the GP took any CI distributions they owe it to the LPs. If GPs are “in the money,” they pay ordinary income up to the “bonus” exercise price threshold, and cap gains thereafter. This to me seems to solve the fairness issue while bridging some of the incentive arguments this blog has consistently contemplated the past couple of years.
In the end, I think it’s intellectually dishonest to put carried interest in the same bucket as salary and bonus compensation that are paid (or not paid) annually versus a fund with a 10-year life cycle where a meaningful portion of compensation is tied to long-term performance.
December 22nd, 2009 at 12:04 pm
This is getting silly. “Let’s make the tax code more complicated” is probably not the right answer here. Also, based on common options taxation principles, Al’s suggestion would still result in paying the ordinary income tax rate.
Have you ever been paid in options by a corporation? The capital gains “clock” starts ticking the day you exercise the option and stops the days you close the position - most people take a “cashless exercise” in which they buy and sell the stock at the same time which means the holding period is effectively zero.
As an example, if I get paid on Jan 1, 2010 with 100 options of company ABC with a strike of $50 and on Jan 1, 2020 (ten years later!) I cash in those options at a stock price of $90 then I have earned $4000 and I pay the short term capital gains tax rate which is equal to the ordinary income rate.
The only way for me to qualify for the long term rate would be to actually use a “cash exercise” which, in the example above would mean I actually PAY my own money on Jan 1, 2020 to buy the 100 shares of stock (I actually write a $5000 check at the $50 strike price). Then I would have to hold those shares until at least Jan 1, 2021 to qualify for the long term rate. You see, the system is rewarding me for putting up my own capital in a risky investment (since there is no guarantee that the stock will be at $90 or even above $50 in one year). It does not reward me for simply taking the cash.
The preferential capital gains tax rate was put in place for a single reason - to get people with money to invest that money in long term investments. It’s actually a really simple concept to understand if you are not trying to distort it for personal gain. A good rule of thumb, is if you haven’t written a check (or made a wire transfer or any other more “tech-centric” form of writing a check) you probably haven’t invested any capital.
Finally, being held accountable for the long term performance of your actions/work is not the same as putting your otherwise idle money to work for the long term. We can see that in the stock option example above. If I was the CEO of company ABC, it was my ten year of effort that drove the company stock from $50 to $90, but if I take the cashless exercise I still pay the ordinary income rate, because that’s how we tax gains made from labor.
December 22nd, 2009 at 11:49 pm
Your interpretation of my comment was entirely too literal of the tax treatment of an ordinary option, but thank you for correcting my “silly” comment and offering your pedantic examples (without going into a paragraphs-long explanation my offered treatment can be practically accomplished in private companies). My intent was to use an option as a viable framework and offer a constructive potential solution to bridge the “it’s either cap gains or ordinary income” argument by saying “maybe it could be both.”
And the tax code is already complicated and littered with structured incentives to influence behavior, so let’s not imply this is a simple issue to resolve. Should we now delve into the “simplicity” of our progressive tax laws surrounding plain ol’ wages, since a $ is a $ after all, and the preferential wealth transfer and subsidizing by the government of individuals of varying income levels? Come on - if you can’t even acknowledge another view other than “$ in $ out is cap gains and you’re an idiot if you think otherwise” then I’ll stop wasting time trying to have a healthy debate.
Paul I apologize for participating in the highjacking of your post you should resubmit and clear out the collective clutter we’ve put forth as this has nothing to do with what you were originally talking about. We’ve taken this thread in the wrong direction - if interested we should re-engage elsewhere.
December 23rd, 2009 at 11:03 am
[...] Memo to Congress. There are legal issues with taxing carried interest as ordinary income. Paul Koenig, peHub [...]
January 7th, 2010 at 11:23 am
One issue that has been ignored is that the additional tax burden could be pushed onto the LPs/Investors at least partially, as VC’s attempt to structure their partnership agreements to offset the increase taxes by either increasing their carry and/or fees to make up for their lower take home pay. This would result in a bigger share of the gross profits going to GP’s and lowering the net returns to LPs. Whether this happens will depend upon the balance of power in the industry, particularly with the larger “top tier” firms. So it is premature to assume that this extra taxation (whether right or wrong) will have no effect on the returns to LP Investors.