Why Barack Obama's Hedge Fund Tax Hike Won't Work

Date: Thursday, June 30, 2011
Author: John Carney, CNBC

Barack Obama’s plans to reduce the budget deficit by raising taxes on hedge fund managers show that he’s more interested in political theater than responsibly dealing with the budget.

When Obama says he wants to end the “tax break” for hedge funds, what he presumably means is he would tax what’s known as carried interest as ordinary income. Currently, it is taxed at the lower capital gains rate.

But the only comprehensive study to look at proposals to tax carried interest as ordinary income found the change would generate very, very little revenue. In fact, because hedge fund managers would change the way they get paid it would likely generate almost no revenue at all.

Before you get all outraged about this, it’s important to understand why it is so easy for hedge fund managers to avoid having carried interest taxed as ordinary income. The reason is this: Carried interest isn’t ordinary income. It’s a capital gain.

Let’s use an example to illustrate this point. Suppose NetNet staffer Cadie Thompson decides she’s learned enough about markets to become an investment advisor. She tells me that she will invest $1 million of my money for a low 2 percent management fee.

A few years go by. Cadie is a brilliant investor. My portfolio is up 100 percent. My original $1 million investment is now worth $2 million.

Cadie takes 2 percent a year of the total, and that gets taxed as ordinary income. My entire upside is a capital gain—a gain on my investment—and only subject to the 15 percent capital gains tax.

Now imagine that instead of just being an investment advisor, Cadie decided she is going to run a hedge fund and charge both the 2 percent management fee and receive 20 percent of the profits.

Everything else is exactly the same. Cadie is doing the same work, I’m investing the same $1 million, we see the same 100 percent, $1 million gain from our investment activity. But this time I get only $800,000 of the $1 million in profits, while Cadie takes the other $200,000.

The only thing that has changed is how we divide up the gains.

What Obama means when he says he wants to end a “tax break” for hedge funds is that he wants to raise taxes on partnerships that share the upside of capital gains between the investors—who have "purchased interests"—and the fund managers—who have "carried interests," or interests they purchased with their sweat equity.

But because the actual gains—prior to distribution between the outside investor and the fund manager—are capital gains, it is easy enough to avoid this taxation. Instead of granting the manager a carried interest in the fund, it would be simple enough to recharacterize the whole thing as a loan transaction.

Here’s how it works. I invest that $1 million but this time only $800,000 goes directly into the fund and $200,000 becomes a loan to Cadie. Cadie uses the $200,000 to buy a 20 percent stake in the fund. So now we both have purchased interests in the fund and our long-term gains can be characterized as capital gains.

Now there are complications. If I charge Cadie interest on the loan, she’ll likely increase the management fee to make up for that. She’ll have to pay ordinary income taxes on that increase but far less than she would if the entire 20 percent were taxed as ordinary income. (If I don’t charge Cadie interest, she’ll have to pay taxes on the imputed income.)

But what’s clear is the government wouldn’t have raised much revenue by shutting down this “tax break.” You aren't going to get a lot of deficit reduction out of this change.