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Tax Policy for Hedge Funds July 19, 2007

Posted by federalist in Finance, Taxation.
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While Congress tries to come up with a rationale for raising the taxes paid by investment company managers, Rick Bookstaber, at his new blog, illuminates the ways in which private equity and hedge funds are just like any other business.

Hedge funds are businesses in which managers are responsible for assessing a set of possible investments and allocating the firm’s capital to the best investments within that set. They are then rewarded according to the results of their decisions. That does not sound a whole lot different than what manager do in any other business. Granted fund managers are compensated for their results in a more formulaic manner than are those in most other businesses, but ultimately they are being compensated based on how well they manage the assets under their control, just as any other business manager is – or at least should be – compensated.

As with all issues of taxation the situation is muddled, but contrary to the insinuations on the left there was no special tax carve-out for hedge funds. Rather (as I understand it) the tax code has two separate rate structures depending on whether money attributed to an individual is a “capital gain” or is “income.” Taxes on the former are almost always much less than on the latter.

Since the occasionally astronomical incentive fees earned by fund managers are entirely contingent on the performance of investments it seems easy to argue that those fees are capital gains. The opportunists in Congress are arguing that the incentive fees are actually “income” that is earned for work performed investing other peoples’ money.

If I were to guess at the “correct” or “fair” interpretation under the currently absurd tax code I suspect the final solution would treat fund manager incentives like stock options, which have both an income and a capital gain component. So hedge fund managers would have to price an at-the-money option of their investors’ capital when they get it, pay income taxes on that, and then take the capital gains or losses on that option depending on their realized incentive fees.

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1. federalist - July 30, 2007

Phil Kerpen clarifies the change Congress is contemplating:

Under current law, individual partners in an investment partnership such as a hedge fund or private equity fund are taxed based on what the underlying partnership income is; if the income comes from a capital gain, it is taxed at the capital gains rate. Ordinary income is taxed at ordinary income tax rates. This tax treatment is consistent with the rationale for a lower capital gains tax rate — to alleviate the double taxation of corporate-source income and to encourage risk taking, entrepreneurship and capital formation.

The legislation Congress is considering ends those protections, saying in effect that it doesn’t matter if the income is a clear-cut capital gain, such as proceeds from the sale of corporate stock. What matters is who receives the income, in this case politically unpopular rich guys.

2. federalist - August 5, 2007

Bruce Bartlett gives us an excellent essay on the history of capital gains taxation. The IRS from its start in 1913 taxed realized capital gains but was repeatedly overturned by the courts.

[I]n Brewster v. Walsh (1920), a federal district court ruled against the IRS’s taxation of a capital gain, saying, “The sale of capital results only in changing its form, and, like the mere issue of a stock dividend, makes the recipient no richer than before.”

Unfortunately, the Supreme Court eventually came around to the IRS view and reversed itself in Merchants Loan and Trust v. Smietanka (1921). Capital gains have been taxed by the federal government ever since.

But our present system of taxing only realized gains is incongruous.

In the 1930s, economists were largely persuaded that capital gains were income after all. Most now subscribe to the so-called Haig-Simons definition of income, which would tax all consumption plus the change in net worth between two points in time.

But on this view, not only would realized gains be fully taxable — so would unrealized gains. In other words, a tax on wealth. And indeed, some liberal tax reformers periodically suggest just that.

Some have said that the Haig-Simons principle requires taxing such things as the imputed rent that homeowners in effect pay to themselves for living in their own home, the economic value of household production by a nonworking spouse (babysitting, cleaning, cooking, etc.), and other forms of “income” that most people would consider outlandish.

Nevertheless, there is still a fundamental distinction between income and capital that remains unresolved. Since the 1920s, Congress has basically split the difference by leaving unrealized gains untaxed and generally taxing realized gains at reduced rates. However, a strong case can still be made that capital gains really shouldn’t be taxed at all. The right rate for capital gains might be zero.

3. federalist - August 9, 2007

Raymond Richman argues that a more appropriate (and practical) solution is to only tax capital gains once they are taken as income, but not when they are “realized” but rolled over into another investment asset that could appreciate.


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