I'm running for Congress in 2008 and tackling the issues of the day right here on my blog.  Today's topic: taxes on carried interest.  For all "Percy on the Issues" posts, click here.



There is a sinister movement afoot to raise taxes on the profits interests granted to the general partners of private equity funds.  The issue has been addressed in the past couple of weeks by two widely read columnists in the popular press,  Andrew Ross Sorkin and Michael Kinsley.  What's interesting about both columns is that neither columnist found it necessary to explain why taxing the profits interests of general partners at capital gains rates instead of ordinary income was wrong.  They wrongness was deemed so obvious that no explanation need be given:

Andrew Ross Sorkin, March 12, New York Times:  "Should the 20 percent fees that private equity firms collect from the profits of its investments be considered capital gains, as they are now, or regular income? It's a giant difference — the tax rate for capital gains is 15 percent, versus 35 percent for regular income. There's no doubt about it: the Internal Revenue Service should clearly be considering it regular income."

Michael Kinsley, March 22, Time:  "Well, one wrong thing is that Uncle Steve's [Steve Schwarzman, head of private equity firm Blackstone] 20% fee gets a huge tax break. It is considered a capital gain rather than ordinary income, so it is taxed at 15% rather than 35%. There is no conceivable justification for this loophole."

The tax treatment of profits interests in flow-through entities has been settled for decades.  All pools of capital established to invest in venture capital (and other private equity), real estate, oil and gas, timber and other investments expected to be held for a year or more are set up to give the folks managing the money a piece of the upside at the same tax treatment as the pool's investors, whether that treatment is long-term capital gain, short-term capital gain or ordinary income.  The policy reasons are the same as those behind drawing a distinction between long-term capital gains, short-term capital gains and ordinary income generally.  Taxing the profits interest of GPs at the same rate as a pool's investors lowers the cost and thus increases the availability of patient capital for new and mature ventures.  It encourages people to take risks that otherwise wouldn't be taken and, hopefully, spur growth and jobs.

Compare the profits interest to what we normally think of as ordinary income — wages or fees paid on a current basis.  A manager gets nothing for its profits interest unless investors get all of their money back PLUS the amount necessary for them to realize a negotiated rate of return.  People paid wages aren't taking this kind of risk or any risk at all.

There may be sound policy reasons for tweaking our the tax laws, but let's hear them.  Let's hear why we should raise taxes on private equity firms by 133%.  Declarations of unfairness and claims of loopholes without acknowledging the benefits provided by pools of capital and the people who run them — and without acknowledging the vastly greater risks associated with them — is no argument at all. 

Vote for me and I'll save our capital markets and make sure the profits interests of fund managers get a fair and equitable tax treatment.

Previously re carried interest.