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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This is a very good explanation. Thanks!!! It really makes no sense to treat hedge fund manager's "income" as capital gains. Do you have any information on how much governments can collect in taxes if they were to change the managers share of the investment to an income as opposed to capital gains. I bet you $10,000 it would be substantial..probably enough to dramatically reduce our debt. haha. Also...A few years back, congress was trying to pass legislation to address that and they were heavily lobbied by hedge funds including bain inorder to keep the status quo.
ReplyDeleteI am sorry I have not got back to you on the other issues you have asked my opinion about. I have NOT forgotten you!!! :) As a wild guesstimate of how much additional revenue the Fed govt would get assume there are 1,000 (probably more) of these guys doing this and each one would on average pay $10 million more in taxes (probably it is less than this)at the 35% rate, then that would be $10 billion more in tax revenue. That is less than 1% of this years budget deficit of $1.2 Trillion. Lets DOUBLE my estimate! Still represents a tiny portion of the deficit. That tells you the scope of the problem with our budget. Having said that, this is a tax loophole that needs to be closed or reformed. Keep the Captial Gains tax (15%) BUT dont let hedge fund managers treat it as if it was their OWN money that created the gain. It is a gain for the investor, but income for the hedge fund guy---boom! That's it. :)
DeleteHey Gene. 10B a year is less revenue then I thought. I figured there are way more then 1000 of those guys out there. Reading more about it...Your estimates are more or less correct..maybe even optimistic. So the savings, although a lot, would not to even scratch the surface of our debt. Nevertheless, I agree they should be paying their fair share.
DeleteI just found a link (below) to a NYTIMES article about Carried interest published last year. The amount is MUCH less than I thought---$17 Billion over 10 YEARS, not one year like I thought it might be! $1.7Billion a year is pocket change in the budget. the article is a nice example of corporate lobbying and the toxic problem of crony-capitialism. Politicians are winning the battle in laying ALL the blame on corporations and "the rich". Better for them and their re-election campaigns. Makes me ill when I see it...
Deletehttp://www.nytimes.com/2010/05/29/business/29carried.html
This site needs a like button, because really, I just like it and have no further comment. But since it requires a comment I will comment, but not really say much of anything except that of course, I like this post and the subsequent dialog that followed the original post.
ReplyDeleteThank you very much, Kablanis...Keep coming back. I post everything you see here on my Facebook page too and that is where MOST of the comments and discussion take place. I get very few comments on this blog page so it only looks like there is not much participation or interest in what I post. :)
DeleteOpps, Bettis, I just figured out it was you!!! :) Hope all is well with you and the family... :)
ReplyDelete