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March 7, 2016
The True Story About the Taxation of Carried Interest
By Alan J. Wilensky

Alan J. WilenskyAlan J. Wilensky served as Treasury deputy and acting assistant secretary for tax policy in 1992 and 1993. He is now a tax lawyer and financial adviser in Minneapolis.

In this article, Wilensky argues that President Obama should change the preferential tax treatment of carried interest, and he explains how.

When Donald Trump and Hillary Clinton agree about an issue, America had better listen. Add President Obama and a host of Wall Street and other political luminaries, and maybe in this era of seeming political paralysis, it is time to take action.

Before the political debate season, most Americans had not heard of "private equity," "hedge funds," or other exotic investment vehicles, which were largely available only to large institutions or very wealthy individuals. The purpose of this article is not to define these investment formats (for simplicity, the remainder of the article will refer to them all as hedge funds) other than to state their most common feature: The managers of these funds are typically compensated with an annual management fee of 2 percent of the amount invested and 25 percent of the profits earned by the investors over the term of the investment.

A simple example will suffice. Let's assume a fund has $10 billion under management. The managers will receive an annual fee of $200 million. Although the managers require some research associates and some administrative support, as well as lavish offices and access to a private jet, it is not uncommon for the top managers to earn more than a $100 million a year. Do this for a few years, and pretty soon you are talking real money. (Has anyone priced a house in East Hampton or Nantucket lately?)

But there is more. If the fund terminates in five to seven years and the financial markets are like those we have experienced recently, a top-performing fund could easily double in value and thereby produce a profit of $10 billion. Twenty-five percent of that amount, $2.5 billion, would be paid to the manager. Now that is real money any way you slice it. A deluxe apartment on Park Avenue, a summer home in East Hampton, a waterfront home in Palm Beach, and a Gulfstream G650 private jet are all within reach. There would even be enough left over to build a substantial art collection and donate a wing to a museum or your alma mater.

But wait a minute. The manager has to pay federal and typically state income taxes on this income. How is it taxed, and why?

Dean Acheson, who served as secretary of state under President Harry Truman, titled his memoir "Present at the Creation." Although my position in government and my influence in no measure approached that of Acheson, I was the senior government tax official during the promulgation of the rules used to justify the current taxation of hedge fund managers. The story should be told, and the situation should be rectified immediately.

I was the Treasury deputy and acting assistant secretary for tax policy in the fall of 1992 when Rev. Proc. 93-27 was approved. Very few hedge funds were in existence, and most of the current managers were in school (many in grade school) at this time. The ruling attempted to address what in the tax world was typically referred to as the Sol Diamond issue -- that is, how do you tax the real estate developer (Diamond, in this case) in the common arrangement in which Diamond is the general partner, provides development services, and puts up little or no money? (Sound familiar, Mr. Trump?) The limited partners put up the money and typically receive their money back and a preferred return before the general partner and the limited partners split the remaining proceeds. Do you tax Diamond when the partnership is formed? Surely it has some value, but how do you value it? The project could easily fail, and Diamond would then receive nothing. Different courts in a large number of litigated cases came out all over the map on when to tax the developer and how to compute the value of the developer's general partnership interest. To end the confusion and to come up with a simple, easy-to-administer rule that seemed fair in most situations, Rev. Proc. 93-27 concluded that the general partner would be taxed at the end of the investment when the exact amount of income could be determined. As a long-term investment, it was taxed as capital gain income. Service income or management fees paid to the developer during the course of the investment were taxed as ordinary income. In no government meetings that I attended did the term "hedge funds" come up, because they had not yet come of age.

In the 25 years since this IRS ruling was issued, these new 2 and 25 percent investment vehicles have emerged and become significant parts of the Wall Street landscape. Their managers follow the Sol Diamond guidance, and the pro-Wall Street administrations that have ensued under both political parties have done nothing up to this point to disturb the status quo. Who are among the largest political contributors to both parties? They would be the people with the most money, many of whom are the managers we have been discussing. Not only are they the sources of very large campaign contributions, but they also hire many of the most senior and powerful government officials after they leave government at historically unprecedented compensation levels. No one wants to close the bar in the middle of a great party.

The secret, of course, is now out. The unprecedented wealth gap between the 99 percent and the 1 percent (really the tenth of 1 percent) is highly visible and has become a significant national political discussion. Let's give Trump some credit: He highlighted the issue, saying he viewed the manager's income as services income, all of which should be taxed as ordinary income at the highest marginal rate. Clinton, Jeb Bush, and some others have followed suit.

But let's change the focus to the person who can make a difference and can do so right now. That person is the president, and he has thus far been quite timid on the issue. He has proposed legislation that would address only a narrow and extremely egregious aspect of the problem. As if it were not enough to receive capital gain treatment on the 25 percent carried interest, some greedy hedge fund managers (is that an oxymoron or a tautology?) have, in the middle of the existence of a fund that is doing well, altered their compensation arrangements to reduce their 2 percent annual management fees taxed as ordinary income in exchange for larger back-end fees taxed as capital gain income -- for example, from 25 percent to 28 or 30 percent. Obama's legislative proposal, which will go nowhere in an election year, would address only this very narrow part of the problem.

So what should the president do? The Lord giveth, and the Lord taketh away. The president can have his Treasury secretary, who supervises the IRS, revoke Rev. Proc. 93-27 and its progeny as it applies to hedge funds and similar investment vehicles and issue guidance clarifying that "carried interest" is taxed as ordinary income in the same manner as the annual management fee. The president is not running for reelection. No one has gone to jail for any of the Wall Street shenanigans that have come to light during his administration, and if he does not act, there is no assurance a future president or Congress will. Perhaps Obama would lose a few post-presidential $250,000 speeches or some large donations for his presidential library, but I have a strong feeling he will do just fine in the afterlife. So Mr. President, just as you have taken so many bold and consequential actions during this past year, I would ask you to take administrative action now to end one of the most egregious and unfair aspects of the federal tax system and have the IRS issue a revenue ruling that would eliminate capital gain taxation for carried interests. This would not eliminate the unprecedented income and wealth gap, but it would be a good start, it would be symbolically important and fair, and it would provide additional luster for your legacy. So Mr. Trump, thank you for doing the right thing at the expense of angering many of your friends. Thank you, Ms. Clinton, for taking the risk of alienating many of your potential large donors, and Mr. President, I hope I can soon thank you for doing the right thing and bringing back some fundamental fairness and integrity to the federal tax system.

Tax Analysts Information

Magazine Citation: Tax Notes, Mar. 7, 2016, p. 1173
150 Tax Notes 1173 (Mar. 7, 2016)