Special Topic: Follow-up on the
Carried Interest debate.
By Robert A. Green, CPA & CEO of
GreenTraderTax and GreenTraderFunds
We covered this hot topic on a prior
conference call and on our blog. This debate is taking on feverish proportions
on Wall Street, in Washington DC, in the mainstream media, and
elsewhere.
Most coverage focuses on attacking the billionaire private
equity and hedge-fund managers who benefit from the lower long-term capital
gains tax rates (rather than paying ordinary income tax rates like almost
everyone else on their working income).
There has been little coverage of potential tax and market
consequences for investors.
Here is one good tax question: If the
carried interest is redefined as ordinary income for managers, will that
reclassification also apply to investors? In other words, will investors face
higher taxes as well because they need to deduct fees rather than have reduced
capital gains? Consider that most investors don’t get the full benefit of
incentive-fee deductions. We considered this question on a prior conference call
and on our blog.
There’s good news on this front from one of our tax
attorneys, Mark Feldman
JD. Investors should not face any tax
changes in connection with current Senate and House bills to revise carried
interest rules.
- We looked at the House bill
and it seems that we need not be concerned that the amounts paid on
carried interests will be non-deductible to the investors who do not
exceed 2 percent of AGI limitation. The bill does not treat this as a fee
paid by the partnership but as a distributive share of the partnership's
capital gains and losses; on the partner level, the manager/partner
treats the income as ordinary income.
- The Joint Committee on Taxation
(2007 TNT 133-9) explains the bill as such:
”The bill generally
treats net income from an investment services partnership interest as ordinary
income for the performance of services. Thus, the bill recharacterizes the partner's distributive share of income from
the partnership, regardless of whether such income would otherwise be treated
as capital gain, dividend income, or any other type of income. Such income is
taxed at ordinary income rates and is subject to self-employment tax.”
- This also seems to the intent of
the House bill, as it provides:
"(a) TREATMENT OF DISTRIBUTIVE SHARE OF
PARTNERSHIP ITEMS. – For purposes of this title, in the case of an investment
services partnership interest –
"(1) IN GENERAL. – Notwithstanding
section
702(b) –
"(A) any net income with respect to such interest for
any partnership taxable year shall be treated as ordinary income for
the performance of services.
Just attacking managers without
hurting investors may make these tax changes more palatable for Congress.
But Congress should also consider that not all carried interest
receivers are billionaires; many are regular, hard-working entrepreneurs (our
clients) forgoing salaries to make a share of capital gains only when their
investors also make those capital gains.
I think the more limited Senate
bill to repeal the carried interest on the private equity firms going public is
much smarter than the more wide-scale House bill attack on all carried interest
receivers.
The House bill is not addressing a key tax-theory concept,
which supports the long-standing carried interest tax break.
The
underlying income in focus is the allocation of capital gains to the managers.
This income is capital gain in the first place, so it doesn’t make much tax
sense to re-characterize it as ordinary income.
Yes, there have been
many tax shelter abuses over the years; where creative accountants, tax lawyers
and brokerage firms have conspired to turn ordinary income into long-term
capital gains with “tax products.” These tax shelters were rightfully busted. In
most, they abused basic tax theory. They did convert ordinary income into
long-term capital gains or no income at all, using phantom loss
techniques.
With carried interest it’s entirely
different. The underlying income is capital gains and it’s usually deferred. The
managers are simply in the same boat as the investors – which is what the
investors want – and they are receiving the same type of income at the same tax
rates. There are no shenanigans here.
Don’t confuse that with some more
advanced tax schemes in the Blackstone deal, where the managers get long-term
capital gains and ordinary tax-loss treatment on amortization of goodwill.
That’s over the top in my view, too.
If Congress strips long-term
capital gains benefits from private equity firms, these firms may have the
incentive to get out of their investments even faster – in less than 12 months,
the holding period required for a long-term capital gain. We should encourage
longer-term investing.
Democratic presidential contender John Edwards
was one of the first political heavyweights to attack the carried-interest
benefit and he now seems to be using it to galvanize his wider campaign to
attack the Bush tax cuts.
But how much credibility does John Edwards
have on tax issues? Didn’t John Edwards avoid payroll tax on more than $50
million in legal fees by running those legal fees through an S-Corp, which is
not supposed to be used by professionals? Senator Hillary Clinton won kudos for
her health care initiative in the early 1990s and she is credited with the idea
for the Medicare (payroll) tax of 2.9 percent applying to all earned income, not
just the social security base (currently $94,200). Senator Clinton is also attacking the
carried interest tax rule.
New
York state senator Chuck Schumer, the
protector of Wall Street, seems to be alone in trying to safeguard the
carried-interest breaks. He says what’s good for the goose should also be good
for the gander, so also repeal the break for oil and gas and farms – which he
knows have even greater political protection in Washington.
But Schumer may feel too much
political heat and have to capitulate soon. He is in charge of raising money for
the Democrats to win the White House, and if this issue is the rally cry, how
can he be caught in this hypocritical predicament? Is Schumer just defending his
constituency and supporters with lip service to keep his stripes?
At this point, the debate is taking
on French Revolution proportions, and it’s going to be hard to stop the riotous
mobs. The private equity and hedge-fund managers are being painted as
Aristocrats, who were tax-free. That is counter to our tax system in place from
day one – graduated progressive tax rates, intended for the rich to pay more.
It’s just too easy to rally Main Street against Wall Street now. The
perceptions reinforced by media de jour are that Wall Street is up to its dirty
old tricks again. Buying and selling Main Street with reckless abandon, using
junk bonds and big-city bank financing, to carve up assets, equity, jobs and
people with little care for the long-term.
This political attack has two
mutually supporting goals: Win votes on Main Street, since those voters greatly
outnumber Wall Streeters; and win political campaign contributions from Wall
Streeters desperate to hold off this tax change.
I have many concerns
about the private-equity craze underway and some fears on how it might play out
in our markets and economy. Take a look at my reply on the New York Times
Deal Book on this issue, at the bottom of this article.
Why did
U.S. stock markets tank the week of
July 23-27? Was it because these issues are real and it’s a problem and/or
because Wall Street is sending a warning shot to Congress to stand down.
U.S. Treasury Secretary Paulson is the ex-CEO of Goldman Sachs, the
pre-eminent Wall Street firm with a great stake in private equity and hedge
funds. Secretary Paulson has said the attack on the carried-interest tax break
is a mistake because there will be collateral damage. He suggests more careful
study first. Secretary Paulson also serves at the wishes of President Bush, who
has defined himself as the tax cutter on investment gains – and he considers
that to include carried interest (both in the oil patch and on Wall
Street).
Remember the old axiom: The Japanese sell Americans Toyotas and
Americans sell the Japanese U.S. T-bills, along with U.S. arms to
defend shipping lanes and oil supplies.
The Chinese sell Americans almost everything (Wal-Mart is their
fifth-biggest trading partner) and Americans also sell the Chinese U.S. T-bills.
Does the T in T-bills stand for tribute? American power is based on
freedom as an ideology, but also as a money concept with free-markets and free
flows of money around the world (global trade and investing). Can Washington politicians,
the seller of T-bills, really attack Wall Street, their partner in profit in
selling T-bills and American stocks around the world?
Let’s ask the
original great hedge funder turned philanthropist and economist and now
Democratic campaign sage (founder of MoveOn.org), Mr. George Soros. I really
liked his book that included his new concept on market “Reflexivity.” Perhaps, Soros learned this concept when
he almost successfully shook down the Bank of England in the early 1990s by
attacking the British Pound. Some argue this led to the Euro, which protects
European currencies from speculator attack.
Soros realized that what matters
most is putting out market fires fast with whatever it takes to prevent a wild
financial fire from spreading out of control. He also realized that governments
should not stand on theory, precedence or political gain, they should just put
out the fire. Reflex leads to another reflex, which leads to another small
change, which finally fixes things.
I wonder what George Soros has to
say about the carried-interest debate now. It can be argued that the
U.S. bull market is on its
last legs and the U.S. is struggling with high debt
loads and bad press around the world. In can also be argued the Asian tigers can
jump ship on their T-bills for product exchanges anytime soon. Is it wise to
have a French Revolution on Wall Street now?
In my view, a strong
argument can be made for taxing gains earned by deal-makers (in private equity,
hedge funds, real estate, oil and gas) as ordinary income.
The Bush tax
cuts did create an even bigger gulf between ordinary income tax rates and
long-term capital gains (20 percent), which caused (over-the-top) tax
professionals and private “wealth managers” (the deceiving Wall Street title) to
become tax alchemists, turning higher tax rates into lower ones.
My beef
is politicizing this issue now and garnering a mob mentality, with little regard
for the true underlying tax concepts and potential collateral tax and market
damage.
Look at the Sarbanes-Oxley (SOX) experience. The debate at that
time was how to fry the Enron, WorldCom and other corporate abusers and prevent
that type of corporate fraud from every happening again. SOX socked it to
U.S. corporations and it’s been an
employment act for accountants and attorneys, which contributed to the private
equity bonanza.
Young
and/or distressed mature companies couldn’t afford SOX compliance costs and
oversight, so some succumbed to the private equity wolves. Private equity firms
repackaged these companies into a fund-of-fund private equity firm, which itself
later went public with reduced SOX compliance costs and oversight. This is a
classic case of over-regulation and fiscal policy having unintended and equally
bad outcomes.
It’s a funny thing about regulation
and high taxes. They push activity to lower-regulated areas and lower taxes.
Look at my article in Active Trader a few years back on hedge funds. I
argued that hedge funds were the least regulated financial service firms and
financial impropriety would seek them out. Private equity firms are just like
hedge funds in this regard, and they even help each other in their pursuit of
profit. http://www.greencompany.com/HedgeFunds/ActiveTraderGreenHedgeFundsJan2006.pdf. Hedge funds assemble voting blocks
and then vote for private equity firm takeovers.
Great fortunes with
great impropriety built America, and they also built Britain, France, and now China and Russia. Attack
the fortune makers and they will find friendlier jurisdictions and new ways to
practice their craft. These days, it’s easier than ever for money to flow
offshore and then back again in the guise of offshore funds. Let’s be smart
about these changes and not have carnage and blood in our Wall
Streets.
Media attackers of the
carried-interest and private-equity players base their argument on the perceived
fact that private equity firms are not risking much money (or really anything at
all) and therefore don’t deserve capital gains treatment (or any special
treatment at all). Others argue that managers are just collecting income from
their services, no different from those who earn a salary.
These
perceptions are flawed. Private-equity firms are risking their hides, just like
the Enron and WorldCom managers. If they rape and pillage an underlying company,
or don’t perform as they represented, or their deals just blow up, they can be
sued for tremendous sums and even face jail time. In my book, that counts as
plenty of risk capital. Certainly more than most who collect ordinary income in
other jobs and professions. Yes, doctors, lawyers and accountants have risks,
but they also have professional liability insurance, and it's not on the same
scale of risk, in my view.
Which one of the media pundits is ready to
quit their job, form their own media property or blog, forgo a salary and try
their hand at the capitalist dream?
Robert Green’s entry on the NY
Times Deal Book blog on June 8, 2007, in reply to an article on the excesses
of private equity:
Deja Vu. In the go-go late 80s, Drexel’s junk bond LBO
craze crashed and burned when a recession coupled with higher interest rates
crashed the brilliant young MBA’s worksheets (forecasting profits). These
worksheets were the entire basis of many M&A deals (not real-world reality).
Declining company profits could not cover rising interest payments and many
deals were unwound.
No problem for Wall Street. They advised the
underlying companies on the original deal and were paid to restructure the deals
for banks, many of whom were bailed out by taxpayers in the simultaneous real
estate crash. Wall Street eventually took many of these companies public again
in the returning go-go 90s.
The current spin on this same
old story may have started with over-reaching SOX, intended to put out Enron
“off-balance-sheet” type fires. It’s sadly ironic because this has led to a rush
to be private to avoid SOX and go even more off balance sheet. Just imagine the
schemes and deal-making that private equity firms can cook up with their Wall
Street and banking brethren, outside of the public’s view, with little reporting
to private equity investors and not enough real business players at the table.
Enron shareholders could sell, but private equity firm investors rarely can with
lockups.
Here’s the big problem and question: Do you really think
the private equity firms can run these target companies better than the existing
management and ownership? I seriously doubt it. Private equity firms’ management
is being stretched very thin with the rash of deals and their managers are
trained as traders and deal-makers, not operating company managers. It’s easy to
insult management, but much harder to make a product that customers want to buy
in a profitable way for the company over the long-term. Plus, private equity
firms add on layers of fees and are accustomed to manipulating companies as
suits them best.
Don’t worry just for the investors,
worry for the workers in these target companies. It’s Enron all over again, with
disappearing jobs and pensions and wrecking of long-standing established
companies.
Yes, lots of existing management
sticks around, but the entire chemistry is off and existing management is not
given enough say.
I view these private equity funds as becoming similar
to a class of Funds of Funds, as they exist in the hedge fund space. Again,
there are probably lots of added fees and conflicts of interest draining the
underlying target companies.
Funds-of-Funds hedge funds and private
equity firms are competing to rush to market themselves as the next high priced
IPO. They are rushing together portfolios, and their MBAs are crunching
worksheet numbers to dwarf the Drexel junk bond guys.
All industry
players have a stake in building this house of cards. It’s all transaction canon
fodder for NYC’s financial power machine, made up of private equity, Wall
Street, banks, big accounting and law firms, and their supportive institutional
and wealthy private investors.
As you stated, this craze is putting
pressure on other public companies to initiate and continue major share
buybacks.
This has the effect of reducing the available stock to buy
publicly, which is classic financial inflation – more demand and less supply.
SOX has not cleaned up the playing field or reigned in the players, it’s
only moved the game into a new arena – private equity and hedge funds.
In my attached article for Active Trader, I pointed out how financial
impropriety moves to the least-regulated entities like hedge funds.
To
date, everyone is winning this game including hedge-fund investors (sellers),
the private equity buyout companies (buyers), the banks (enablers), the service
firms (selling the gold picks and shovels) and even online traders (based on
hype with volatility).
But these types of cooperative power plays based
on hype usually end badly for many investors.
If things turn bad – as
you point out from rising interest rates – how will investors in private equity
funds and hedge funds sell their interests? The answer is they are locked in
usually and they won’t be able to sell. How convenient is that for the power
players? SOX and liquid securities protect investors, but few investors are
protected in hedge funds and private equity funds.
Plus you rightly
pointed out that bond investors in these deals may rush to sell and drive up
interest rates even further.
