Politicians are ducking Wall Street's most important tax loophole

David Nelson
David Nelson

Wall Street’s dirty little secret

By David Nelson, CFA

Let’s start by stating the obvious. Avoiding taxes is the national pastime. Since the dawn of organized society special interest groups have employed petitioners to lobby for better treatment under the tax code. I’m sure even in the days of Egyptian Pharaohs, there was a cottage industry helping some avoid taxes on cooking oil. Today, an army of lobbyists has descended on Washington like locusts to preserve or establish a loophole to cut the tax burden on their clients.

When it comes to special interest groups, there’s nothing more special than hedge funds, real estate and private equity firms. Carried interest is one of those Wall Street terms that forces a yawn as you roll your eyes looking to change the TV channel. Your lack of interest is just what the industry is hoping for. If current proposals from both the House and Senate are an indication of the final tax reform package, then once again your government has failed you protecting one of the most egregious tax loopholes in modern history.

Before we get deep into the forest, let’s establish just what carried interest is and why it’s important. Carried interest is a share of the profits paid to an investment manager in excess of the amount the manager contributes to the partnership, often called a performance fee. The advantage is, under current tax law much of that income is magically transformed into capital gain taxed at just 23.8% rather than as ordinary income which for many private equity, hedge fund and real estate managers would be the top rate of 39.6%. Private equity enjoys the biggest benefit as more of its investments are held long term, unlike hedge fund counterparts who trade frequently.

According to the Tax Policy Institute, a non-partisan think tank out of Washington, private equity was controlling $3.8 trillion as of 2014. The math is pretty simple. It doesn’t take long to realize that with a potential 20%-30% performance fee, there’s a lot at stake.

Of course, supporters of carried interest say it’s an incentive to get better performance out of money managers. Excuse me, Hello?! If your money managers aren’t doing the best they can regardless of the fee paid, go to their offices and tell them: “You’re fired!”

Top Private Equity Contributors 2017-2018

Source: OpenSecrets.org

Hedge funds have been big political donors for some time, but recently private equity firms may be sensing they have the most to lose, and they are quickly making their political clout known. OponSecrets.org (Center for Responsive Politics) says private equity has recently increased its campaign contributions and lobbying efforts to fend off legislation aimed at boosting the tax rate on private equity managers’ earnings.

The industry’s arrogance is captured in the 2010 comments of Blackstone Group’s chief executive Stephen Schwarzman. He compared any attempt to shut down the carried interest loophole to war, saying, “It’s like when Hitler invaded Poland in 1939.” He’s apologized since, but I suspect this is the sentiment throughout much of the private equity community.

Politicians duck the issue

Making the rounds last week, Secretary of State Steven Mnuchin was speaking to the merits of the current GOP tax bill as he tried to deflect hard hitting questions from Fox Business news anchor Trish Regan. Later that day, former Chief of Staff to President George W. Bush, Karl Rove, dismissed carried interest as too small to deal with now.

When the first version of the House bill was released, carried interest wasn’t even mentioned. Chairman of the House Ways and Means Committee Kevin Brady thinks he’s solved the problem by extending the holding period to 3 years. It’s an insult to believe this somehow changes the outcome. The average holding period for private equity is over 5 years. In the end, those on the receiving end give up nothing.

House Ways and Means Committee Chairman Kevin Brady, R-Texas, left, calls for a short recess to consider his manager’s amendment, to the objections of Rep. Richard Neal, D-Mass., right, the ranking member, as the GOP tax bill debate enters a final day, on Capitol Hill in Washington, Thursday, Nov. 9, 2017. (AP Photo/J. Scott Applewhite)

I don’t blame the financial community for using the loophole. It is entitled to do everything it can to lower the tax burden. It’s the politicians who take their money and behind closed doors do their bidding.

There will be those who point to this as a GOP giveaway. There’s nothing partisan about it. Supporters for carried interest exist on both sides of the aisle. I doubt a change in the balance of power in 2018 or 2020 would tip the scales the other way.

Candidate Trump campaigned against carried interest saying, “Hedge fund guys are getting away with murder.” I understand politics is about compromise, but every now and then you come across something so wrong and unfair, you have put your foot down. Mr. President, respectfully, this is one of those times.

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