Sympathy for the Devil. The devil is “carried interest” taxation of partnerships interests. Megan McArdle discusses this devilry in Sure, Debate Carried-Interest Taxes. Or Something That Matters.:
It’s fundraising gold for Democrats, and a perennial talking point for liberal columnists: hedge funders pay taxes on some of their income at the lower rate for capital gains, rather than the higher rates assessed on “ordinary income” (read: money you earn by working).
If you only know about it from politicians, you get the idea that the only beneficiaries of the carried interest are hedge fund managers who light their cigars with $100 bills. If you see it in tax practice, though, it looks different.
The “carried interest” is really a profits interest, or a preferential allocation of profits, to an employee or manager of a partnership. A private equity manager might get no current equity in an investment, but a portion of the profits. The same rule lets a partnership give an interest in future earnings to the business’s managers or employees. It’s a partnership version of stock options (options are allowed for partnerships, but the differences between partnership and corporation taxation makes options less attractive in partnerships).
Carried interest opponents find this “abusive” when the business does well and gets sold. The result is a portion of the gain on the sale of the business goes to the managers and employees with carried interests, who may have not put cash into the business. But it’s the same total amount of gain taxed. It’s just that some of it gets allocated from the investors to the managers. The investors are presumably fine with it because they have gain to share — that’s why they cut the managers and employees into the deal in the first place.
But isn’t this abusive because it treats “compensation” as capital gain rather than ordinary? Not really — the investors are forgoing the same ordinary deduction, so the net effect is the same. There’s no conceptual reason why a profits interest — which by definition has no value when granted — can’t generate capital gain. (Of course, I think taxing capital gains in the first place is the real abuse). And in many cases the carry includes an allocation of ordinary business income in tax years prior to the sale, so for that part of the deal, there’s not even a conceptual abuse.
Ms. McArdle is puzzled about the attention the issue gets:
The carried interest issue is thus a convenient way for Democrats making stump speeches to claim that they’re really going to do something about inequality and cronyism, and maybe fund some important new spending on hard-working American families. With the entrance of Jeb Bush and Donald Trump into the arena, it is also a way for Republicans to seem tough on rich special interests while simultaneously proposing tax plans that will help affluent Americans hold on to a lot more of their income and wealth.
As with most Washington Issues, my actual level of concern about carried-interest taxation hovers somewhere between “neighbor’s bathroom grout drama” and “Menudo reunion tour.” Nonetheless, I’m beginning to wish that Congress would get rid of it without demanding anything in return, just to force politicians to talk about something that actually matters.
I’m less willing to just go along. Any “reform” of carried interest will complicate an already byzantine partnership tax law. It will inevitably create traps that will cause tax pain for people just trying to run their business and put beans on the table. At worst, it can become a potential nightmare like the Section 409A rules, which were enacted to punish long-defunct Enron, but which now menace any employees who have a deferred comp deal with their employer.
And of course any carried interest “reform” won’t shut up those who want to jack up taxes on “the rich” for more than a moment before they find another hate totem.
Related, but not agreeing: Peter Reilly, President Obama Could End Special Tax Treatment For Two Twenty Guys
Don Boudreaux, a blogging economics professor, makes a good case against the Export-Import Bank that works just as well against state “economic development” subsidies and tax credits (my emphasis):
Second, subsidies doled out by governments weaken, not strengthen, their economies. To see why, suppose that other governments conscript all 22-35 year olds within their borders and force these conscripts to work at subsistence wages for the industries located within those countries. Further suppose that the results are beneficial for corporate shareholders in those countries: their companies export more and rake in higher profits than they would without such conscription. Should Uncle Sam therefore follow suit?
Economically, the only difference between export subsidies as they exist today in reality and the above hypothetical is that real-world export subsidies are less extreme than is conscription. Yet no essential economic difference separates real-world subsidies from such hypothetical conscription: each is a government policy of forcibly seizing resources from some people in order to bloat the purses and wallets of other people.
Substitute “economic development tax credits” for “subsidies” and “other states” for “other countries,” and you have the case against the tax credits paid for by Iowa taxpayers to lure and subsidize their competitors.
David Brunori, A Word of Advice for Legislators of All Stripes (Tax Analysts Blog). You should read the whole thing, but I especially like this: “That politicians can impose economic policy through tax incentives is more akin to a Soviet five-year plan than to anything Adam Smith ever said.”
Robert D. Flach, IRS UPDATES PER DIEM RATES FOR BUSINESS TRAVEL
Russ Fox, TIGTA: “IRS Can’t Track International Correspondence.” IRS: “So What.” “It turns out that the IRS doesn’t know what happens to much of the mail the agency sends overseas.” And it doesn’t much care.
As you read about bonuses, you might recall other reports saying that 61% of IRS employees caught willfully violating the tax law aren’t fired, but may get promoted.
And people wonder why anyone might not want this organization regulating tax preparers.
News from the Profession. Accounting Had a Toxic Culture Before It Was Cool (Leona May, Going Concern). “As ‘The Great Email Chain of 2013’ demonstrates, the public accounting workaholic culture has spawned a whole bunch of work-obsessed, white-collar monsters.”
Well, our little firm isn’t so monstrous. If you feel abused and would like to live in Central Iowa, drop me a line. We might be able to improve things for you.