Sunday, July 1, 2007

Hedge Fund Management Fee Tax Quiz

Assume for a moment, you managed the money of a group of private investors. They paid you handsomely for your work. Each quarter you make a fist full of dollars. Your accountant says you have to pay taxes.

Do you:

A. Pay tax on your work managing other people's money as earned income, which means you also have to pay withholding taxes?

B. Pay tax on your work managing other people's money as ordinary income. Remember ordinary income has a top bracket of 35%.

C. Pay tax on the fees generated by your work as capital gains? Remember the maximum capital gains rate is 15%. No withholding taxes required.

If you said A. you have a firm grasp on way most of us are taxed when we work for our money. If you said B. well you are wrong (for now.) If you said C. you are probably a hedge fund manager getting rich beyond the wildest dreams of avarice and being taxed at among the lowest rates on the planet.

Now what if some folks in Congress looked at how you were paying taxes on what is essentially earned income and decided to close your most excellent loophole.

What would you do?

A. Work doubly hard to make more money?

B. Smile knowing that the jig is up? Or

C. Lobby every Congressman or woman you can find harder than Lockheed Martin trying to sell Star Wars.

If you answered C. you would be correct. According to Donny Shaw at the Congress Gossip Blog the proposed tax increase for private equity and hedge fund managers is the number 1 issue being lobbied right now.

There are three bills currently before congress--H.R. 2834, S.1624, and H.R.2785.

They all attempt to do basically the same thing: alter the tax code so that fund managers' performance fees, the fees from which their profits are derived, are taxed at the normal income rate of 35%, not the 15% capital gains rate they are currently taxed at.
Although I think it is obvious since the tax break costs taxpayers $4 to 6 billion a year, Dana Chasin of OMBWatch, guestblogging for TPMCafe, explained why managers of private equity and hedge funds should be taxed at the normal rates:
By industry custom, private equity fund managers' fees are largely, if not entirely based on the investment performance of the funds they manage. This fee structure rewards managers commensurately with the appreciation of the assets under their management. It is a contingency fee, similar to the fee that an attorney earns from a case taken on a contingency basis. Yet no one would suggest that the lawyer's contingency fee income be taxed at the lower capital gains rate.

Why not? Because the lawyer's fee does not arise from the sale of any assets. By the same token, private equity fund managers may not own a penny of the assets under their management. Like lawyers in our example, fund managers run the risk of earning nothing, if the contingency in question does not eventuate. But in neither case do they run the risk of a financial loss, since they are not investors. Without holding and selling fund assets, their income is ordinary income, not capital gains, and should be taxed accordingly.
I understand how contingent fees are taxed. I bet bmaz wishes his accountant was clever enough to talk the IRS into taxing contingent fees at capital gains rates.

Before you start blaming those nasty Republicans for the current state of the law, you might want to know that according to John Feehery hedge fund employees are more likely to support Democrats than Republicans.