In my last diary, I explained how hedge fund managers are taxed and briefly discussed the fix to the law that has been proposed. I was mainly driven by the proliferation of misunderstandings about how this area of tax operates: misstatements and half-truths on blogs and in the media are, unfortunately, more common that accurate statements and truths.
Now I can add WSJ to the list of media that don't understand the first thing about hedge fund taxation.
TaxProfBlog points to this utterly inane WSJ editorial. A subscription is required, but TaxProfBlog excerpts enough of the op-ed for us to see just where the WSJ fails miserably in comprehending tax law:
The relevant passage:
In a little-understood provision, the Levin-Baucus bill would impose a new "enterprise value" tax on the sale of part or all of any investment firm that has ever earned even $1 of carried interest income. So instead of paying the capital gains tax rate on the sale of such shares, the owners would have to pay ordinary income tax on the proceeds of the sale. This means that owners in private equity firms or real-estate trusts would be taxed twice at a rate approaching 40%—first at the time the money is earned and again at the time of the asset sale. The combined tax rate would therefore rise well above 50%.
The WSJ, then, reads the hedge fund tax fix as taxing the managers twice on the same income: first on the distributive share, then again on the sale or redemption of the interest. Because this is fairly complicated area, let's look at an example: you invest $1,000,000 in my hedge fund, and as the manager I'll be entitled to 20% of the profits. The first year, I make $100,000 for the partnership. Under the proposed law, my 20% cut of $20,000 will be taxed at ordinary income rates rather than at whatever rate the income is in the hands of the partnership (see my previous diary for more on this concept of "pass-through taxation"). After that great year, I decide I want out of the hedge fund business and decide to sell or redeem my interest. Since my $20,000 profit was never distributed to me, my hedge fund capital account has $20,000 in it, and so I sell it for that much. Here's where the WSJ shows its ignorance: in their fever-dream of secret socialists controlling the reins of government, my sale will generate a gain of $20,000, and that gain will be taxed at ordinary income rate of 35%.
Double-tax! Why, it's practically confiscatory!
Well, in the WSJ's nonsensical interpretation, it may be, but that's not at all how the law actually works. First, let's look at the relevant language (PDF!):
Section 710
(b) DISPOSITIONS OF PARTNERSHIP INTERESTS -
(1) GAIN.—Any gain on the disposition of an investment services partnership interest shall be
(A) treated as ordinary income
So far so good, WSJ: gain on sale of partnership interest by a hedge fund manager will be considered ordinary income.
How do we calculate this "gain on disposition" for a partnership interest? When we sell an asset like a stock, the gain is the difference between what I got for it - the proceeds - and how much I paid for it - the basis. In partnership tax law, there's an additional concept called "adjusted basis." We can see how that concept works by looking at house sales. Say you buy a house for $100,000. Over the next few years, you spend $50,000 to add a deck and replace the roof. Your basis is $100,000, but the law permits you to add those improvements to basis. While your basis is $100,000, your adjusted basis is $150,000. When you sell the house for $200,000, your gain is the proceeds less the adjusted basis, meaning the gain on the sale is $50,000.
Partnership tax has something very similar. Here's 26 USC 705:
The adjusted basis of a partner’s interest in a partnership shall...be the basis of such interest...
(1) increased by the sum of his distributive share for the taxable year and prior taxable years of—
(A) taxable income of the partnership as determined under section 703 (a)...
(2) decreased...by the sum of his distributive share for the taxable year and prior taxable years of—
(A) losses of the partnership
Or: if I contribute $1,000,000 to a partnership, make $80,000 of taxable income, and then sell the partnership interest for $1,080,000, my gain is zero. My adjusted basis is $1,000,000 in contribution + $80,000 of my taxable income from my distributive share of the partnership.
Now we can return to the first example and look at it in reality-based fashion. I've made $20,000 for myself based on my carried interest, and under the new law that has been taxed as ordinary income. My basis in the property is zero (remember, the carried interest is given to the hedge fund manager; she doesn't pay anything for it), but to reach adjusted basis I add the income that I've been taxed on. So, my adjusted basis is $20,000. When I sell the interest for $20,000, my gain is zero: proceeds of $20,000 minus adjusted basis of $20,000 = zero. Where the WSJ fails spectacularly is in failing to understand that the adjusted basis provisions are designed to prevent the sort of double taxation that they decry.
Why is section 710 important in the grand scheme of the loophole-closing re: carried interest? Not all income is taxable. If the house you own increases in value, you have "unrealized income" on which you don't pay tax. That unrealized income is only taxable when you realize it, eg when you sell the house. Similarly, a hedge fund may have unrealized income from increase in value of its stock positions, but that income will only be taxable when the stocks are sold and the income realized. So, let's say you own a hedge fund, and you make $20,000 in unrealized income. By contrast, my hedge fund realized its income and I had $20,000 in realized, taxable income. In the first year, I pay 35% on my income, and have $0 capital gain when I sell my interest. I've paid tax of $7,000 over the life of the fund. Let's say you also sell your interest for $20,000. Because your income was all unrealized, your adjusted basis is $0 and you have a gain on sale of $20,000. If we didn't have Section 710(b), your gain would be taxed as long-term capital gain, and you'd pay $20,000 x 15% = $3,000. You and I have both had identical economic performance, but because your fund didn't have any realized income, you get a huge tax windfall. Effectively, by deferring all realization events, you're able to convert ordinary income into long-term capital gain income and save a bundle in tax. The point of 710(b), then, is to prevent those sorts of shenanigans and equalize treatment of income for hedge fund managers by taxing gains on disposition as ordinary income.
A smart provision aimed at preventing another loophole from cropping up rather than the first salvo of socialism as the WSJ would have it.
(I gotta start changing nappies and getting ready for the day, so I won't get a chance to see any comments or make any corrections for a few hours.)