As is evident from my previous diaries on the taxation of investment partnerships and the proposed fix pending in Congress, there are a ton of misconceptions surrounding how private equity and hedge funds are taxed. To a certain extent, I've grown inured to them, since there are only so many times one can read that "hedge fund managers are taxed at the flat rate of 15%" before one just stops caring.
Today, though, I read a story in the NY Times that absolutely took the cake. One passage, in particular, was so bad and filled with falsity that I had to step back and marvel at the effort it must've taken to cram so much wrong into so little space.
The offending passage:
That provision would require the founders of hedge funds to pay ordinary income tax rates on proceeds they received from selling their firms.
Let's start with the most obviously wrong part. The implication here (made explicit one sentence later) is that taxpayers typically pay capital gains tax on proceeds from sales. This is fantastically false: taxpayers pay tax on the gain, not the proceeds (which is why we call it a "capital gains tax," rather than a "proceeds tax"). An example: I buy a stock for $100 and sell it for $120. I have a cost basis of $100, proceeds of $120, and a capital gain of $20. I pay tax on the gain of $20 (which is taxed at either 15% or 35% depending on whether I've held it for a year). Sales of partnership interests are no different: I contribute $100, sell it for proceeds of $120, and pay a tax on the $20 gain.
Error #2: the ordinary income rate isn't levied on "hedge fund founders." It's not uncommon for a hedge fund manager to have two distinct pieces of property. First, most contribute some amount of money to the partnership they run (in exchange for a "limited partnership interest"), and the current bill doesn't change anything for the tax treatment of those limited partnership interests. On top of that, they'll have a profits interest, aka "the carried interest," which entitles them to some percentage of the profits (typically 20%). Importantly, under current law that interest is valued at zero for tax purposes. This is obviously insane: try to buy a carried interest from a private equity manager for $1 and explain that, since it's more than zero, she should jump at the offer. Ya probably won't get very far. The proposed change doesn't apply to hedge fund managers, but the shit that they get for free. (no capital contribution, no tax on the receipt of a very, very valuable piece of property)
Third error: in the ordinary course of things, there will be very little gain on the sale of a partnership interest. And that's because partnership tax works with something called "adjusted basis." Here's how it works: when you earn money inside the partnership or make contributions, it increases your basis (it adjusts it upwards). When you lose money or take distributions, it decreases your basis. When you sum up all the increases and decreases over the years, you get your adjusted basis. And if the NYTimes writer (a) knew jack-all about tax and (b) read the bill, s/he would've found this:
(C) BASIS ADJUSTMENT- No adjustment to the basis of a partnership interest shall be made on account of any net loss which is not allowed by reason of subparagraph (A).
In other words, standard basis adjustment rules (found at 26 USC 705) apply with one minor exception. In the vast majority of partnership dispositions, the gain or loss on disposition on a multi-million dollar interest doesn't exceed a thousand bucks or so. (see my previous diaries on why this measure preemptively closes a potential loophole)
Fourth error: the provision doesn't require that a hedge fund manager recognize ordinary income on disposition. When the carried interest is received, the receipt of the interest is considered ordinary income (which it should under the general principles of the tax code):
(4) PARTNERSHIP INTERESTS- Except as provided by the Secretary, in the case of any transfer of an interest in a partnership in connection with the provision of services to (or for the benefit of) such partnership--
`(A) the fair market value of such interest shall be treated for purposes of this section as being equal to the amount of the distribution which the partner would receive if the partnership sold (at the time of the transfer) all of its assets at fair market value and distributed the proceeds of such sale (reduced by the liabilities of the partnership) to its partners in liquidation of the partnership
The very next section tells us that the manager can affirmatively elect out of that:
B) the person receiving such interest shall be treated as having made the election under subsection (b)(1) unless such person makes an election under this paragraph to have such subsection not apply.'.
What happens if the manager doesn't elect out, but treats receipt of the interest as an ordinary income event?
In that case, it's a "qualified capital interest," and is treated like any other partnership interest. In keeping with that, gain on disposition is treated as capital gain:
6) SPECIAL RULE FOR DISPOSITIONS- In the case of any investment services partnership interest any portion of which is a qualified capital interest, subsection (b) [treating gain on disposition as ordinary income] shall not apply to so much of any gain or loss as bears the same proportion to the entire amount of such gain or loss as--
`(A) the distributive share of gain or loss that would have been allocated to the qualified capital interest (consistent with the requirements of paragraph (1)) if the partnership had sold all of its assets at fair market value immediately before the disposition, bears to
`(B) the distributive share of gain or loss that would have been so allocated to the investment services partnership interest of which such qualified capital interest is a part.
In other words, if one's interest at the time of sale is the same as it was at the time of inception (eg, more interest hasn't been allocated to the manager), the gain will be considered capital gain.
Sorry for the paucity of links and analysis, but this Times piece was a dreadful, embarrassing hitpiece against a pretty well-crafted piece of legislation. It was so hacktacular that I just had to vent. So, I guess this qualified as a rant.