Sweat Equity and the Problems with Taxing Carried Interest

One of the tax-raising measures which has gained currency among many policy wonks is changing the tax treatment for carried interest, a significant source of compensation for successful “alternative” investment managers: hedge funds, private-equity funds, venture capital funds, and others. Carried interest is taxed at the long-term capital gains tax rate of 15 percent, not the top personal income tax rate of 35 percent, which many see as unfair. Except that it isn’t that simple.

First, it’s worth explaining how these alternative investment funds work. Let’s say I personally decide to buy 1,000 shares of Apple’s stock. If I hold those shares for longer than a year, and they go up, and I subsequently sell the shares, the profit I make is defined as a long-term capital gain, and is taxed by the government at 15 percent. (Short-term capital gains, from assets held for less than a year, are taxed at my ordinary income tax rate.)

Alternative investment funds are limited partnerships, in which a small group of individuals or entities pool their assets and agree to jointly manage them. If that pool of assets generates returns, the partnership distributes the profits in a mutually agreeable way. Profits from these pooled investments are taxed in the same way that profits from individual investments are; i.e., long-term investments are taxed at the long-term capital gains rate. This is a long-standing principle of tax law: that members of a partnership are taxed as if they had individually engaged in the partnership’s activity. Think about it: why is it fair for the government to tax me as an individual one way, but tax me at a higher rate if me and my friends get together and invest our money jointly?

But, some say, allowing that principle to stand in the case of hedge-fund managers isn’t fair. Labor and investment are different. When these managers invest other people’s money, and get a share of the returns above and beyond their own personal investments in the fund, they are being paid to do a job, and they should be taxed on their compensation as if it were ordinary salary.

This, too, isn’t that simple. Take our Apple example again. Steve Jobs is a billionaire, and it’s not because Apple pays him a billion-dollar salary. It’s because a significant amount of his compensation has been in the form of stock options; i.e., partial ownership of Apple Inc. in the form of equity, if Apple shares exceed a certain price. These options are taxed at the long-term capital gains rate if they are held for longer than a year after they’re exercised.

Nobody seems bothered by this arrangement when it comes to Steve Jobs. His compensation doesn’t merely come in the form of salary, but also “sweat equity” in which he is rewarded for helping to build a successful, profitable company. It is arguably the single most important financial reward for entrepreneurship in America.

Sweat equity is, in effect, the same principle that is used in alternative fund manager compensation: the people who do the most to drive the fund’s returns; i.e., the fund managers, are rewarded by the fund’s partners with an increased equity stake in the firm.

In other words, raising taxes on fund managers doesn’t close a loophole. Instead, taxing carried income at ordinary-income rates actively discriminates against investment partnerships, by taxing them in a different way than equity compensation is taxed in other settings. (I discuss this further in a follow-up post.)

And that gets us to the final, but usually unstated, sentiment: that investment managers should be actively discriminated against. Unlike Steve Jobs, who builds useful and enjoyable products like iPhones and laptops, fund managers are mere speculators, who profit from the trials and tribulations of the broader economy, and don’t serve a socially useful purpose. This argument, in my view, is misinformed, but I’ll save that discussion for another post.

Avik Roy — Avik Roy is the President of the Foundation for Research on Equal Opportunity (FREOPP.org), a non-partisan, non-profit think tank.

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