Thursday, January 26, 2012

This post is for those of you who don't quite understand (but want to!) the main technical issue surrounding compensation of Hedge Fund managers (related to Romney's "Tax Problem")...Objective analysis then my opinion on it...

Let me use as simple an example as possible to illustrate the point, because I am a simple man.

I am going to start my own Hedge Fund (or Private Equity Fund). I am going to be the lead investor of funds for 100 people who each have $1,000,000 to invest with me.  Because I am a GREAT investor with a GREAT track record, all these investors are confident of my ability to get them GREAT returns on their investment. 

I am going to tell these 100 investors that they don't have to pay me ANYTHING until I make them money.  Because I am shouldering quite a bit of risk in doing this, I am going to charge them 20% on whatever I earn them OVER their original investment of $1M. 

On day one of the opening of my Hedge Fund I have $100M to invest. I do.

I go play lots of golf in the meantime.  In exactly one year (365 days) I go and check the fund balance and I see the total value of the fund is now $120 million!  I have made a "Capital Gain" (the money over and above the original investment) or $20M. Converted into an interest rate that would be 20%. That is pretty darn good!

I quickly call my investors and tell them the good news. Assume all of them say "SELL!".  I tell them their CRAZY to sell today and they should wait until TOMORROW!!  Here is why...

If I sell a "qualified investment" in less than one years time any interest earned is taxed at a marginal tax rate of 35% (the highest tax bracket for any income earned over approx $365,000). Any interest earned from an investment that is cashed in AFTER one year is taxed at 15%. This 15% is what is termed the "Long Term Capital Gains Tax Rate". 

After the investors pay me my 20% fee (20% of the $20 million in Capital Gain is $4 million) they divide the remaining $16 million between them. Each of the 100 will get $160,000.  If they sell now, they will each pay $56,000 in taxes (35% of $160,000) or if they wait one more day they will pay $24,000 in taxes (15% of $160,000). Which would YOU choose to do?

All this is background to get down to how this affects ME.  Most people would think the $4 million I received from operating my Hedge Fund would be classified as "income" paid to me by my investors for doing a good (no, great!) job for them.  Call it income, a commission, whatever, but when I do my tax return I have to claim it as income, therefore putting me in the highest tax bracket of 35%, right? I should write a check to the IRS for about $1.4 million, right??  Hold your horses, Al Capone!

Remember the source of my $4 million was from the original $20 million in interest, or Capital Gain.  For my investors after waiting more than one year to cash in were eligible for a the lower tax of 15%.  Guess what? I AM TOO!! My portion is called, under interpretation of the tax code,"carried interest" Defined here:

""Carried interest is not interest in the sense of an interest-bearing savings account. It is a share in a fund. The person claiming that interest is the general manager of a private equity firm or hedge fund, and the carried interest is calculated as a percentage of the profits generated by the fund he manages. When the fund has a capital gain, the manager's percentage is treated as a gain to him, taxed like an ordinary capital gain on the sale of real estate or stock. Critics say this particular income source does not fit the correct definition of capital gain and should be taxed as wages.""

So, on my $4 million I pay $600,000 in taxes as opposed to $1.4 million.  Good deal for me, right?!?!

I don't won't to question the efficacy of capital gains OR the taxing of them.  I think it is clear the value these gains on the economy AND we can have an honest debate as to how much we should tax them. I get that and you should too.

However, I do think it is relatively clear the way these gains are treated for the purposes of compensating Hedge Fund managers is not in accordance with reasonable tax policy and interpretation.  In other words, it is not "fair" in any sense of the word...

How does this relate to Mitt Romney? Throughout is career he has been on BOTH sides of the illustration above.  Money he earned from the Hedge Fund/Private Equity Fund he operated (Bain Capital) was taxed at the lower rate and the money he himself save from his earnings that he invested is/was taxed at the lower rate as well. A double capital gains dipper, if you will...

What do you think? Tell me where I am right or am wrong. 

After all, I am just a squirrel trying to understand the nuts...
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