I wrote in my previous post that I would blog on carried interest shortly.
Hedge funds earn income in two ways. First, they charge their customers a management fee, usually something on the order of 1.5 percent. Second, they take a hefty slice of the capital gains earned in successful investments, often 25 percent.
So, say a man has a $1 million account at a hedge fund and, after a very successful year, his account is worth $2 million. The fund would charge him $30,000 as a management fee and take $250,000 as its share of the profits, leaving him with $1,720,000 in the account. Even with the large fees, a 72 percent return on capital in a single year ain’t bad.
But the hedge Fund owners only have to pay tax on their share of the profit at the capital gains rate, 15 percent. Why?
It beats me. Unlike the customer, they have no money at risk (they don’t share in any net losses). It is a pure fee for service, although, to be sure, measured in capital growth. Hedge fund managers don’t deserve a tax break on their fees any more than lawyers, dentists, or, alas, writers do.
But, why didn’t the Democrats, who ran both houses of Congress from 2007 to 2011, bring this to a screeching halt? Good question. Could it, perhaps, have something to do with the fact that hedge fund managers tend to share these windfalls with politicians in the form of campaign and PAC contributions?
I believe it is because the hedge fund manager is a partner in the fund himself and not just an employee. He thus structures his take not as compensation (which would be taxed at the higher rate) but as a share of the profits entitling him to capital gains treatment. n nIt's similar to what Buffett does, not taking a whole lot of high-tax salary compensation but rather lower taxed capital gains and dividends. I don't know but doubt that Buffett takes 20% off the top, but the structure is relatively the same…. 'owners' who control the firm can tweak their pay package to minimize taxes. n nWhile I don't like the effect of this practice, at least as far as the hedge funds, it's hard to eliminate without screwing what I'll quote/unquote call 'real' partnerships…
If hedge fund managers are allowed to continue perverting the definition of capital at risk and capital gains, then we can be sure that some time in the future the special tax treatment of such gains, so central to capital formation and investment, will disappear.
I think that this is outrageous. I don't think that politicians or hedge fund managers would get away with this in Australia. All political contributions have to be published in Australia–unless they come in via a brown paper envelopes. Fund raising is part of the political process. Industry and labor unions can make open or secret contributions but both are damage the democratic system. Politicians are supposed to represent constituents not interest groups. In so far as democratic nations take this road the prepare the way for dictatorship.