Thursday, September 20, 2012

Joint House-Senate Hearings Examine Hedge Fund Carried Interest as Part of Federal Tax Reform

A joint House Ways and Means and Senate Finance Committee hearings on tax reform discussed the treatment of capital gains and carried interest in the current federal tax code. Professor Leonard Burman, of Syracuse Business School, testified that, in 2012, the biggest tax shelter may arise from the fact that certain forms of compensation are taxed as capital gain.  For example, managers of private equity funds and hedge funds hold a carried interest, a right to receive a share (typically 20 percent) of the profits produced by an investment fund over and above any share corresponding to their actual cash investment.  As a result, a significant portion of their compensation is ultimately taxed as capital gain, rather than ordinary income.  Private equity managers also receive fees that are taxed as ordinary income, but if the investments are successful, that is a small portion of their compensation.   

Besides for the obvious inequity of people with multi-million dollar earnings being taxed at lower rates than middle-income workers, a disparity that at least in part motivated the Buffett Rule, he noted, this is also economically inefficient.  While there probably would be a role for private equity funds even in the absence of the capital gains tax break, he reasoned, it is surely true that more people and capital are drawn to such firms by the tax breaks.  

Data compiled by the Internal Revenue Service suggest a marked shift in the kinds of assets that generate capital gains over time. In 1997, more than half of capital gains came from corporate stock, either held directly or indirectly through mutual funds. Only 30 percent was generated by so-called pass-through entities: S-corporations, partnerships, trusts and estates.

Ten years later, corporate stock was less than 40 percent of all long-term gains while pass-through entities comprised more than 44 percent.  Over that same period, there was also a very large increase in the dollar amount of pass-through gains, 296 percent, compared with a 91 percent increase for stocks and mutual funds.  In the Professor's view, the growth of private equity firms, which are typically organized as partnerships, and other investment partnerships might be a significant factor in this shift.   

David Verrill, Chairman of the Angel Capital Associaiton, distinguished between angels, venture capitalists and private equity.  Angels invest their own money in management teams and technologies they like, typically where they live.  So angels are on Main Street of every state in the US.  Venture capitalists typically invest institutional capital from endowments, corporations and family offices. Private equity, much like VCs, invest institutional money but their focus is on mature companies. 

He cautioned Congress that raising the capital gains tax rate significantly will force many angels to broadly turn away from an asset class in which they are the most experienced, recognized experts and dominant players.  At a time when crowdfunding and general solicitation by issuers are about to come into play under the JOBS Act, he reasoned, the wisdom of angels is going to be needed more than ever to maintain discipline and order in this market.