How Should Hedge Funds and Private Equity Be Taxed?

It seems like Congress goes into attack mode anytime somebody is making a lot of money. In some cases I agree with our elected officials and in other cases their arguments make little sense if you look at the big picture. Take the oil companies for instance. We all know the industry is swimming in money. If Congress aims to repeal subsidies these firms get from the federal government, I have a hard time opposing the idea. Our country does not need to subsidize our oil companies. However, if you propose some kind of excess profits tax simply because oil prices are high, that is ridiculous. We live in a market economy and markets are cyclical. You can’t tax companies during boom times just because you feel like it.

Anyway, the topic du jour is the taxation of hedge funds and private equity funds. Again, we have a group of wealthy people who are making billions and paying the same (if not less) taxes as the average worker. To figure out where I fall on issues like these, I try not to bring politics into it at all. To me, it’s logic-driven reasoning that should rule the day and help form an opinion.

I haven’t been following the issue that closely, but the sticking point is the fact that hedge fund and private equity fund general partners split investment profits with their limited partners. The investment managers serve as general partners and collect 20% of the profits from the investments they make, which is often taxed as long-term capital gains, at a rate of 15%. The fact that someone can make $100 million and only pay 15% in taxes is evidently upsetting a lot of people in Washington.

At first blush it might seem like the 15% tax rate makes sense. If a hedge fund has $100 million in assets and earns 10%, there is $10 million in profit to be divided up. Assuming an 80/20 split, the manager makes $2 million and the limited partners share $8 million based on their ownership percentages. Since the $10 million in profit was the result of capital gains, then it is easy to see why some feel the 15% tax is fair.

There is one difference though, that seems very important. The whole point of having a low capital gains tax rate (relative to income tax rates) is to incentivize people to invest in businesses and put their capital at risk. Such actions are the life blood of our capitalist system. In return for risking your own money by investing in other ventures that need funding, you are rewarded with a lower tax rate on any profits you earn.

The problem is, hedge fund managers aren’t risking their own capital a lot of the time. They are pooling money from their investors and managing it for them. Sure, they don’t earn anything unless they produce positive returns, but if they lose money, they don’t lose as much, if at all, because they typically have less capital at risk, if they invest in the fund at all. This seems like the most logical reason why one would be against the 15% tax rate for hedge fund managers.

Now, it’s true that most fund managers have invested some of their own money in the funds they manage. Perhaps what the tax law needs to say is, when you have your own money at risk, you can claim profits as a capital gain, but when your investors are simply sharing a portion of the profit earned on their capital, in return for your management ability, then that income should be treated as a management fee, and therefore taxed at ordinary income tax rates.

It’s a tough issue for sure. I just hope the law going forward reflects reality, meaning that if you get a tax break for capital gains, it better actually be your capital that was put at risk in order to produce the gains in the first place. A fair compromise in my eyes would be to allow managers to pay 15% on the portion that is their own capital at risk, and ordinary income tax rates on fees earned on limited partner’s assets that are paid out to the general partner. That way, the whole point of the 15% capital gains tax rate (reward risk taking with lower taxes) is preserved.

What do you think?

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5 Thoughts on “How Should Hedge Funds and Private Equity Be Taxed?

  1. Anonymous on July 2, 2007 at 6:35 AM said:

    Way too logical to ever get done.

  2. mOOm on July 2, 2007 at 8:31 AM said:

    I think the argument is that the incentive/performance fees are of the nature of ordinary income and should be taxed at regular rates. I didn’t think congress was making this argument regarding profits on the manager’s own investments in the fund. This does make sense to me. The main argument in favor of lower long-term CGT in general in my opinion is compensation for inflation as the nominal gain is taxed. For example Australia used to index the gains but now has switched to half the normal income tax rate instead. Also when the capital gain results from reinvestment of profits in the business CGT amounts to double taxation like in the case of dividends in the US. But even Australia double taxes this (it doesn’t double tax dividends derived from profits earned in Aus).

  3. sagacious on July 2, 2007 at 2:44 PM said:

    From what I can tell, the bigger issue is that corporations are taxed 35% on capital gains while LLCs are taxed at 15%, yet these partnerships operate almost identically to corporations, down to partnership interests trading just like stock certificates. In other words, otherwise identical operations but with the primary difference really coming down to how they’re shown on paper.

    Forget raising LLC tax rates. I say corporate capital gains tax rates should be lower.

  4. shtove on July 3, 2007 at 10:36 AM said:

    It’s not a tough issue at all – no risk, then tax as income, not capital gain. It shouldn’t even be an issue for new legislation – just apply the existing rules.

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