Senate Debates Tax for Private Equity, Hedge Funds

Private equity and hedge fund managers argue that "carried interest" should be taxed as capital gains, and not as compensation.
Alan RappeportJuly 31, 2007

Senators probed private fund managers and tax experts Tuesday to determine the need for a controversial tax hike for hedge funds and private equity firms. Proposed legislation would force managers of private funds to pay the same tax rate that corporations and individuals pay on income.

At issue is whether carried interest — in most cases a percentage of investors’ profits — should be taxed at the capital-gains rate of 15 percent or as compensation for services, which would incur a 35 percent tax. Congress proposed legislation last month to address the disparity. Proponents of the change argue that wealthy fund managers are being subsidized and unfairly rewarded for “performance bonuses,” while detractors say that the proposed tax increase targets only one of the many industries that use the “carry” practice and would stifle incentives for riskier investments.

“There is little difference between a large private equity firm and a Wall Street investment bank,” Sen. Max Baucus (D-Mont.) said at Senate Committee on Finance’s hearing on Tuesday. “Both offer a wide array of investment strategies for their clients. But only one claims that the income from an active business is passive and is subject to capital gain treatment.”

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To be sure, managers of private equity firms and hedge funds argued they are heavily invested in the fortunes of their funds and say the tax benefits enable them to take the risks that yield such superior returns. Private equity firms are not just servicing other people’s money, according to Bruce Rosenblum, managing director of private equity firm The Carlyle Group and chairman of the Private Equity Council. “We are co-owners with limited partners, not their employees,” he said. He added that the companies his firm owns are capital assets and that the sales of those assets are capital gains, to be taxed accordingly.

The issue of taxation on carried interest came to the forefront last month when private equity firm The Blackstone Group made its public offering. Some lawmakers saw the transition as highlighting the glaring difference in the tax treatment Blackstone faces compared with other companies.

However, fund managers warned at Tuesday’s hearing that interfering with current tax treatments could discourage other funds from going public. “Many firms like ours will conclude that the burden exceeds the benefit,” said John Frank of Oaktree Capital Management.

While private equity practitioners have been trying to stave off a change in their tax treatment, academia has been promoting the opposite track. The “two-tiered” tax system distorts career choice and fails to to protect investors, argued professor Joseph Bankman of Stanford Law School. “Fund managers are different than entrepreneurs,” he said, explaining that tax incentives for the latter help promote innovation. Meanwhile, Charles Kingson, a lecturer at the University of Pennsylvania Law School, argued that the gap between the “2 and 20” — the typical hedge fund fee scheme composed of the percentage of assets managed and percentage of profits — is pure compensation and should not be taxed as a capital gain.

Similarly, Paul Krugman, a Princeton economist and New York Times columnist, has compared the tax treatment of management fees to book royalties (which pay a higher tax), and Alan Blinder, also a Princeton economist, wrote in the New York Times this week that although the “carry” is derived from capital gains, it is mostly someone else’s capital, not the fund manager’s.

But not all scholars favor a tax increase. Professor David Weisbach, of the University of Chicago School of Law, recently produced a research paper funded by the Private Equity Council, claiming that arguments for taxing carried interest are misplaced and would do little good. Private equity firms invest much like any other investor or business, he says, and returns on their capital gains should be taxed the same way. “The only difference between carried interest and direct investments is the use of limited partnerships instead of debt as a means of financing,” according to Weisbach. “It does not make sense to change the tax treatment significantly based on this difference.”

Some senators at Tuesday’s hearing seemed sympathetic to those who think hiking taxes on carried interest would be a blunt instrument. “If you single out one piece on some theory, that theory may have serious impact on other deals and on how capital is created,” said Sen. John Kerry (D-Mass.).

Such differing opinions could stall any legislative plan to change the tax treatment. A potential compromise could include “grandfathering” changes to the tax rule, thus protecting existing relationships for firms that benefit from their status. Others have suggested a compromise that would tax the initial value of carried interest as regular income and future returns at the lower capital-gains rate.

Ultimately, the resolution could come down to semantics. “We have to make up our minds whether this is compensation or whether it’s capital gains,” Sen. Charles Grassley (R-Iowa) said.