Carried Interest

Mitt Romney earned a hefty 21.6 million dollars in 2010. But he paid a measly 13.9% of that in income taxes to the Federal Government. Under current law, any "ordinary income" over $380,000 is taxed at 35%. Various loopholes, deductions, and legislative oddities make it possible for Romney to pay a smaller share of his income in taxes than your doctor probably paid.

Mitt did not do anything illegal. But the tax code that makes this possible is deeply flawed. Romney benefited from a concept called "carried interest." Before explaining any further, I am compelled to offer the following warning: learning about carried interest might upset you and/or make you less willing to pay your income taxes. It is a bogus concept. Supporters of carried interest often resort to contortions of logical reasoning to justify its existence. Indeed, recent columns in prominent publications like the NY Times and Bloomberg have done exactly that. My aim below is to offer readers a clear explanation of carried interest and an easy to understand critique of some of the recent articles that have attempted to defend its continued existence.

The first thing to understand is that the American government currently taxes income that individuals make by working at different rates than it taxes income people earn by investing. Income earned by working is taxed according to a bracket that ranges from 10% for lower earners to 35% for the highest earners. Certain types of investment income, on the other hand, receive special treatment and are not subject to the taxes as specified in the bracket. Income earned from dividends and long-term capital gains (a long-term capital gain is the money made from price appreciation on an investment that is held for at least one year) is currently taxed at only 15%.

Ok, so money earned by working is taxed differently than money from dividends and long-term capital gains. Put that knowledge aside for a moment while we go over the basic structure of investment partnerships like hedge funds, private equity funds, and venture capital funds. The details of how these firms make money is not very important. Just know that all of them are hired by institutions like pension funds, university endowments, and wealthy individuals to invest their money strategically. The investment partnerships charge a fee for this service. A typical fee structure is known as "two and twenty" in Wall Street lingo. If a private equity fund charges "two and twenty" it means that it keeps 2% per year of any money the client invests and 20% of any gains. So, let's say a pension fund gives a hedge fund $10,000,000 to invest on its behalf for 2 years. At the end of the 2 years, the $10 million has grown to $13 million. But the pension fund will not be getting $13 million back. The private equity partnership will keep $400,000 because 2% x $10,000,000 x 2 years = $400,000. It will also keep a 20% performance fee for the $3,000,000 gain it achieved, which equals $600,000. So, the partnership will keep a total of $1 million and the pension fund will receive $12 million.

Now let's talk about taxes. The private equity fund did not risk any of its own money. The partners of the private equity fund received $1,000,000 in fees. You might think that the $1,000,000 in fees should be treated as ordinary income subject to the ordinary tax bracket. After all, the private equity partners did not invest their own money to create this $1,000,000 in profit; all of the income takes the form of a fee paid for a service (the service being strategic investment). Somehow, Congress and the IRS have agreed to allow the partners to treat the $600,000 performance fee as a capital gain. Therefore, the private equity partners only have to pay a 15% tax rate on the $600,000 of income. The thinking is that because the private equity firm has a share in the profits of an investment, the resulting income should be treated as investment income. This logic fails to account for the fact that the private equity firm is not investing its own money. Rather, it is performing work on investors' behalf. Whether the investor wants to pay the private equity firm with a fixed fee, a share of the profits, or a lifetime supply of M&M's, the compensation should be treated as ordinary income.

Gregory Mankiw is a frequent NY Times columnist, Harvard economics professor, and advisor to the Romney campaign. His column on March 3 attempted to explain carried interest by positing some theoretical examples, three of which I reproduce below:

• Carl is a real estate investor and a carpenter. He buys a dilapidated house for $800,000. After spending his weekends fixing it up, he sells it a couple of years later for $1 million. Once again, the profit is $200,000.

• Dan is a real estate investor and a carpenter, but he is short of capital. He approaches his friend, Ms. Moneybags, and they become partners. Together, they buy a dilapidated house for $800,000 and sell it later for $1 million. She puts up the money, and he spends his weekends fixing up the house. They divide the $200,000 profit equally.

• Earl is a carpenter. Ms. Moneybags buys a dilapidated house for $800,000 and hires Earl to fix it up. After paying Earl $100,000 for his services, Ms. Moneybags sells the home for $1 million, for a profit of $100,000.

Carl would be able to treat his $200,000 profit as a capital gain because he invested his own money. Under current partnership law, Dan would be able to claim his $100,000 income as capital gain because he has been given a carried interest in Mrs. Moneybag's investment. On the other hand, Earl would have to pay ordinary income tax because he was paid a fixed fee for his work. Mankiw writes:

In some ways, this treatment makes sense. After all, Dan is doing half of what Carl did, so why should he have to pay a higher tax rate than Carl did on that half of his income? On the other hand, it seems that Dan is getting off easy. Dan does not seem very different from Earl, because both are getting $100,000 for fixing up the house.

If these examples leave your head spinning, you are not alone. Economists and tax lawyers who study these issues are unsure about the best way to handle these situations in practice.

Here is where carried interest enters the picture. Carried interest from a private equity partnership is like the income that Dan earns from his real estate partnership. In this case, however, Dan is not a carpenter but a specialist in business turnarounds. The partnership does not buy dilapidated houses to fix up and sell; it buys troubled businesses to fix up and sell. And just as Dan the carpenter can treat his share of the partnership income as a capital gain, Dan the business specialist can do the same.

Mankiw says that "Dan is doing half of what Carl did" and therefore it is reasonable that they should both pay the advantageous capital gains rate. This is not true. Unlike Dan, Carl invested his own money. Carl's savings were at risk if the project went South, whereas Dan's savings were never part of his arrangement. It makes sense that Carl's gains are treated as a return on investment. It does not, however, make sense that Dan's compensation should be treated as investment income; Dan has not invested any capital. He has simply performed a service for Ms. Moneybags and they have agreed that his payment will be a share of any profits.

Bloomberg News recently ran an opinion piece entitled "If Carried Interest Irks You, You Don't Get It", written by a tax attorney named William Dantzler. Dantzler makes the valid point that there is sometimes a grey area between working and investing. He cites the example of an entrepreneur who works to build a company and then enjoys the benefit of the lower capital gains rate when he sells that company for millions of dollars, despite the fact that he never really invested significant financial capital:

Bill Gates has a capital gain when he sells Microsoft Corp. (MSFT) stock even though, by most accounts, Microsoft would not exist without his considerable effort. Similarly, the distinction between capital gains and ordinary income has never been based on the amount of money invested or, indeed, whether there was any investment at all. An entrepreneur who starts a business with no investment (or more likely an investment by someone else with money) still generates capital gains on the sale of her business, and it is sometimes said that this fact accounts for the vibrancy of the tech economy in the United States.

What then would be the basis for saying that a private- equity executive with a carried interest should have his percentage of the capital gain from the sale of an underlying investment recharacterized as ordinary income? Is it because he sweats and the other investors don’t?

Dantzler is higlighting the fact that investors who both invest their own capital and perform some work that increases the value of that investment receive a special tax advantage; despite the fact that they have performed work and invested, all of their profits can be treated as capital gains for tax purposes. There is something a little unfair about a system in which an entrepreneur can convert the profits he earns by working - as opposed to investing - into a capital gain. If Bill Gates or Carl the Carpenter performs work that increases the value of an investment, the value of that work should theoretically be taxed as ordinary income. But Dantzler incorrectly suggests that because some entrepreneurs receive an unfair benefit, we must also extend this largesse to private equity managers. The problem of entrepreneurs receiving a special advantage is not remedied by creating a special tax law that arbitrarily includes investment partnerships in the lucrative arrangement. Why not also include doctors, waitresses, and teachers? Dantzler then proceeds to suggest that from a legal perspective, "It would be very hard to draw a fair line between the type of private-equity investment that is deserving of capital gain treatment and that which is not." In reality, it would be pretty straightforward: Anytime wealth is transferred from one party to another as a form of compensation (ie., a performance fee for investing), it should be considered ordinary income.

Now, if this discussion leaves you wondering if capital gains taxes should even be lower than ordinary income taxes in the first place, you are not alone. Many people argue that this system should be abolished. Indeed, the Tax Reform Act of 1986 equalized the rates for a few years. However, there are also many valid arguments in favor of a two-tiered approach. That debate is for another day. The point of this discussion is that given that we have such a system, there should not be a special exception for partnerships that allows private equity managers to avoid paying billions of dollars in taxes.