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Friday, July 29, 2011

The Carried Interest Tax Loophole

President Obama recently gave a primetime speech. One thing he said was (paraphrasing) "We should close the carried interest tax loophole, but the stubborn Republicans are blocking it." The Daily Show mentioned this excerpt.

One of my coworkers worked for many hedge funds, and he didn't know about the carried interest tax loophole. A lot of these stupid laws and loopholes persist, because most people don't know about them.

The carried interest tax loophole enables a hedge fund manager to pay ridiculously low tax rates, even though he's earning ridiculously high fees.

A hedge fund manager gets a huge "management fee", typically 2/20. "2/20" means a fee of 2% of assets, plus 20% of any gains. Already, you should see this is flagrant price gouging.

Why do hedge managers get away with such high fees? Some are idiot wealthy clients with parasitic financial advisers. A lot of hedge fund money is pension money.

Due to the Principal-Agent Problem, the incentive is for the pension manager to line his pockets at the expense of beneficiaries. Here's how it works. The pension manager says "I'll invest $1B in your fund if you hire my brother-in-law for $1M/year.", or another such under-the-table arrangement. Therefore, most of the money invested in hedge funds is *EXPLICITLY* for the purpose of skimming wealth. If the hedge fund manager makes high-risk bets, how can anyone know if he did a great job, lousy job, got lucky, or was unlucky?

Before I realized that the State financial system was a scam, I considered trying to become a hedge fund manager. Unfortunately, "hedge fund manager" is a corruption game that only insiders may play. Even if I'd be a top performing manager, I'm barred from that career path. Now that I'm more enlightened, if I were an honest financial planner, I'd advise people to be 100% unleveraged in gold, for which they don't need an expensive manager.

I'll get back to the carried interest tax loophole. The hedge fund manager charges a high 2/20 management fee. Instead of taking the management fee in cash, the hedge fund manager gets paid via newly issued shares of his fund.

So what? The difference is the carried interest tax loophole. If the hedge fund manager took his fee in cash, then it would be ordinary income. By taking his fee in new shares, it's a capital gain!

According to the carried interest tax loophole, when the fund manager takes his fee in new shares, it's treated as shares purchased with a cost basis of zero. If those shares are held for at least a year, then it's a long-term capital gain (max 15% rate) instead of ordinary income (35% plus 2.9% Medicare).

So, a tax rate of 37.9% is converted via the carried interest tax loophole to 15%.

It's actually a bigger tax break than that. For ordinary income, you owe tax *IMMEDIATELY*. For carried interest loophole shares, the manager doesn't owe tax *UNTIL HE SELLS*.

For example, suppose the hedge fund manager holds the shares for 5 years before selling. Then, his annualized tax rate isn't 15%. It's closer to 3%! In addition to the lower tax rate, the capital gains treatment allows the hedge fund manager to defer realizing income.

If the fund manager uses a trust or other tricks, he can completely dodge taxes. The fund manager can hold the shares for 10 years, owing zero taxes and accumulating value as the shares appreciate. Then, he can donate the shares to a charitable trust that he controls.

When the charitable trust sells the shares, that isn't a taxable transaction. The hedge fund manager hires his children and other relatives to be trustees of the charity, drawing a salary.

The correct answer is "All taxation is theft!" However, the carried interest tax loophole is an embarrassment that should be eliminated. It's offensive that hedge fund managers receive humongous direct and indirect State subsidies, and then dodge taxes on their stolen booty.

As usual, hedge fund managers spend a ton of money lobbying to prevent Congress from closing this loophole. Most people don't know about the "carried interest tax loophole". State laws and regulations are filled with loopholes and tricks like this.


Anonymous said...

I live in a high tax Western country. Income tax (20% income tax + 11% National Insurance + about 10% employer's payroll tax) is 41%. VAT is 20% on most things you buy. Council tax is 1500 pounds a year and that is after your money is already taxed.

Despite high taxes I got injured at work, but slipped through the safety net and ended up unable to work and having to live off my savings. Obviously my savings were less than they would have been due to high taxation.

So basically I did real productive work and had to pay high taxes. When I needed government help I was told to get lost (or words to that effect). I had to live off my savings until my body naturally healed itself.

Yet you tell us these highly paid hedge fund managers dodge tax and live off our pension money.

This is outrageous.

The trouble is that so many things in our society are outrageous people just turn off.

Scott said...

Also, there's no FICA tax on capital gains is there? So that's another 15.3% (except for this year).

FSK said...

FICA tax only applies to the first $100k of income (approx). That's why I left it out of my comparison.

However, if the hedge fund manager has no cash income and all carried interest, he also dodges FICA taxes.

I forgot to mention this in the original post: The carried interest loophole also applies to CEOs who pay themselves with options and share grants.

Scott said...

OK, thanks, but basically that extra 15.3% tax applies to the 99% of the US working population, just not to these cats.

Scott said...

With these fat cats it's like "Oh I am making a billion dollars a year, why the fuck should I have to pay ANY taxes at all? Isn't it enough that I have to pay tens of thousands in bribes to congressmen to advance my agenda? That's me paying my fair share!"

FSK said...

Some pro-State trolls frequently say "What are you complaining about? Federal income tax rates are only 25%!" They ignore the Medicare+Medicaid+FICA tax.

Scott said...

Right, or that, unlike in other countries, most people pay state income tax on top of federal, and a few places have county and city as well. There are of course then the property taxes which go up with reassessments each year, and the sales tax, also unemployment tax is a percentage taken out of your salary even though you never see it as a line item. It's not difficult to have more than 50% of your income go to taxes, even if you have a relatively modest income. But then Warren Buffett points out he pays much less percent in taxes on his income than his middle class secretary does.

I'd like to see all income and sales taxes eliminated and reimplement heavy tariffs on all imports.

FSK said...

The correct answer is "All taxation is theft!" Income taxes, property taxes, and the inflation tax are the most evil taxes.

However, if the Libertarian fairy magically reset tax rates to only a couple percent, then I'd probably just pay and focus my efforts elsewhere.

With a total tax rate more than 50%, I'm really a slave of the State.

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