Cliff Beacham CPA | email cliffbeacham@cpa.com | California | Tel: (949) 813-1349
Carried Interest
What does it mean and where does the term come from?
Confusing to conceal?
Carried interest can be a confusing phrase. The word “interest” is generally understood to mean interest
payments for a loan. With carried interest, the reality is much different. Carried interest has nothing to do with
interest payments. It is based on the concept of 'having an interest or a stake in the results.'
Once upon a time - Captains and kings?
Once upon a time there were merchants who wanted to trade overseas. Owners and Captains
of ships undertook to carry the goods over the seas and entered into agreements with the
merchants. They would carry the goods at no risk to themselves other than their ownership of
the carrying vessel – the ship- and in return they would charge 20% of the profits.
The modern equivalent is that today's VCs compensate themselves with 20% of the profits from their funds and
this is called “carry” or “carried interest”.
The ship was at risk which was the investment by the Owner and/or Captain and limited to their
ship. They sometimes traded on their own behalf as well and you could get rich by filling
multiple roles.
It
is therefore, a performance fee.
If you consider a 'hurdle rate' then it could be called a bonus for performance. However, the tax
treatment of this has, in the past, had a motivational effect built in to encourage entrepreneurs, so
it contains a political or economic tool rather than a straightforward interpretation. Similar effects
are the deductibility of mortgage interest to help people invest in their own home as a
social/economic tool/device. There are many other tools used by governments all over the world
not just the USA.
Note: 'carried interest' is not the only compensation that private equity managers receive. They also charge
management fees, which are generally 2%. So if the fund’s performance is bad for whatever reason, they still
get paid. Obviously, the goal is to be a top performer so you can maximize your pay and your career growth.
Capital Gain?
Hysterically, I mean historically, so-called' carried interest has been treated as a capital gain for tax purposes
in most jurisdictions. The reason for this treatment is that a fund manager (the Captain) would make a
substantial commitment of his own capital into the fund and carried interest would represent a portion of the
manager's return on that investment thus being treated as a capital profit instead of earned income.
Compensation
Because the manager is compensated with carried interest (interpreted as a share of the profits), the bulk of
the manager's income from the fund is taxed as a return on investment (capital profit) and not as compensation
for services as manager.
Wikipedia puts it this way: Because the manager is compensated with carried interest, the bulk of his income
from the fund is taxed as a return on investment and not as compensation for services.
Tax treatment
This tax treatment originated in the oil and gas industry of the early 20th century, when the actual oil
exploration companies which used financial partners' investments, had their profits taxed at the capital gains
rate.
This has been lower than the rate for ordinary income for much of the 20th century, in order to encourage risk
and entrepreneurship. The logic was that the financial partners’ sweat equity had entailed the risk of loss, if
their exploration did not pan out
In the same way a Fund Manager faces a loss (or does he? - only on HIS investment) if his efforts do not result
in a gain – it is treated as a capital loss.
Mitt Romney
31% of presidential candidate Mitt Romney's 2010 and 2011 income was carried interest.
This is a political hot-potato and continues to be the subject of discussion and argument one can only wonder
at the wider implications. Take a pass-through partnership situation – any return from a
partnership will come under consideration. Capital gains are the result of selling the
partnership – distributions from the partnership profits are income.
Taxable income?
In my mind a performance bonus is taxable income! Selling your share of the fund so that
your investment is now less is a capital gain. Unfortunately the issue is clouded because
there are no defined shares in the fund only an investment account. The argument is that
inside the fund it is profit and If the asset grows inside the fund because of an increase in
value of the investments it is capital gains and a withdrawal of investment should be a capital distribution
US Government
On February 26, 2014, House Committee on Ways and Means chairman Dave Camp (R-MI) presented draft
legislation which proposed raising tax on carried interest from the current 23.8% to 35%.
In June '15, Sander Levin (D-MI) introduced the Carried Interest Fairness Act of 2015 (H.R. 2889) to tax investment
advisers with ordinary income tax rates.
Two hats
A fund manager wears two hats – investor and manager. They could be separated into two
people. Perhaps the answer Is to tax the performance gain of the manager's own
investment (basis) as a capital gain and the share of the return on every other investor as
income - a bonus for doing good for them. Surely I cannot make a capital profit on
someone else's investment – it may be capital to them but it is a bonus to me because it is
my job and not my investment and, hey, I don't share the losses. The 'at risk' rule seems to apply here.
International implications
However, the plot sickens when you think that many hedge funds are headquartered in the
Caymans and the manager may not be a US taxpayer. Are we to say then that we will tax
an American when a British fund manager will not get taxed? In our present world this
raises more questions than it answers.
Example:
John Paulson started Paulson & Co a hedge fund in 1994 with $2m. In 2011 Paulson & Co, managed $38b in
funds with a between 1 & 2% management fee and 20% of the profits. The fund by 2016 has lost about 50% of
its investments to come in at $18b while Paulson is worth between $8b & $12b. And I thought it was only the
IRS who shared our profits but not our losses! At least we can refer to them as 'high rollers.'
High rollers
Talking of High Rollers – how's this list of the top 20 hedge fund managers:
Who
How much they earned 2015
Ken Griffin
$1.70b
James Simons
$1.65b
Steve Cohen
$1.55b
David Tepper
$1.20b
David Shaw
$700m
John Overdeck
$600m
David Siegel
$600m
Isreal Englandeer
$550m
Ray Dalio
$500m
George Soros
$300m
Andreas Halvorsen
$280m
Jeffrey Talpins
$250m
Chris Hohn
$250m
Joseph Edelman
$250m
Michael Platt
$225m
Chase Coleman
$200m
Steven Schonfeld
$175m
Peter Brown
$150m
Robert Mercer
$150m
Daniel Och
$135m
We'll stop here – I have to go and throw up.
A billion here, a
billion there!
Sen. Everett Dirksen