Everyone needs an advocate, even the super-rich, so let me step up in defense of hedge fund operators. The WaPo has an interesting story telling us that Congress was considering the closing of a tax loophole that saved hedge fund operators millions in personal income taxes, but that strategic donations to key Democrats seems to have allowed the hedge fund heroes to buy their way out it. However the WaPo makes no attempt at all to present the logic of hedge fund taxation or to explore the likelihood that hedge funds could easily re-structure to evade the "closing" of the loophole.
Democrats Split Over Bill Affecting Backers
Tax Measure Targets Hedge Funds
Washington Post Staff Writer
Wednesday, November 7, 2007; Page A01In early June, as the Senate Finance Committee began examining how a new breed of Wall Street titan could be paying a special low tax rate on executives' salaries, one of the richest of them, hedge fund manager Steven A. Cohen of SAC Capital Advisors, cut the Democratic Senatorial Campaign Committee a check for $28,500.
Just days later, with DSCC Chairman Charles E. Schumer (D-N.Y.) equivocating on legislation to raise taxes on publicly traded equity firms, hedge fund giant James H. Simons, who earned $1.7 billion last year at his Renaissance Technologies LLC, donated another $28,500 to the DSCC.
By late July, Schumer was off the fence -- and on the side of the hedge funds and private-equity firms in opposing the Democratic legislation.
And Mr. Weisman of the WaPo goes on to explain how Dems have provided the best Congress money can buy:
The legislation would plug two obscure but highly controversial tax loopholes, deftly exploited by an industry that leans heavily Democratic. Private-equity fund managers earn much of their compensation by taking a cut of clients' earnings. It is pay for work, but critics of the arrangement note that it is taxed as capital gains, at 15 percent instead of the 35 percent income tax rate that they would otherwise pay.
...The second measure in the House bill would shut down fund managers' abilities to shift compensation to offshore tax havens and defer tax payments on that money for years. Closing that loophole would reap the Treasury nearly $23 billion through 2017.
...
But the wealth of the Democrats' target has proven to be a treasure trove for party fundraisers. Hedge funds and investment firms have been pouring money into Washington, contributing $11.8 million in the first nine months of this year to candidates, party committees and leadership political action committees.
That is more than the $11.3 million they gave in all of 2005 and 2006, according to the Center for Responsive Politics. More than two-thirds of that money has gone to Democrats.
Their contributions to congressional candidates, congressional campaign committees and congressional leadership PACs total nearly $4.8 million this year, well over the $3 million given in 2005 and 2006. Eighty-three percent has gone to Democrats, compared with the 53 percent they received in the last election cycle.
Cohen earned $900 million last year, according to the magazine Institutional Investor's Alpha; he lives in a 32,000-square-foot mansion in Greenwich, Conn., with an indoor basketball court and a pool, and he owns some of the finest contemporary art in the nation. If his income breakdown is similar to the industry average, $180 million would have been subject to a capital gains tax of 15 percent, yielding $27 million. That is $36 million less than what he would have paid if the income were taxed as ordinary pay.
In the past two years, Cohen has given the DSCC $55,200, plus $24,450 in campaign contributions to Sen. Joseph I. Lieberman (I-Conn.) and $4,600 to Senate Banking Committee Chairman Christopher J. Dodd (D-Conn.), according to the Center for Responsive Politics. Both senators are undecided on the issue, their spokesmen say.
My goodness - in order to stave off an annual tax hike of $36 million (but please note past performance cannot assure future success) Mr. Cohen donated roughly $85,000 over the last two years. Either Congress represents one of the great values of the age or Mr. Cohen is not really that worried.
And why might he be unworried? Well, it is possible that Senators who stop demagoguing long enough to study the issue have become persuaded that this is a feel-good tax hike that won't actually raise any revenue. As reassurance that it is not only Senators that demagogue, the WaPo does not actually address the substantive issue or attempt to evaluate that possibility either. But here we go!
Peter Orszag of the Congressional Budget Office made a presentation on hedge fund taxation last July. Here are some excerpts:
Treatment as Capital Gains or Ordinary Income
The second issue is the character of the income received as carried interest. Under current law and regulations, carried interest is treated in the same way as all other profits from the partnership for tax purposes. In particular, carried interest flows through to the general partner on the basis of the nature of the income from the underlying investments. Thus, if the carried interest arises from realizations of long-term capital gains on the investments held by the fund, the general partner is taxed on the carried interest at the long-term capital gains rate. In the paradigmatic private equity case, most profits arise from long-term capital gains, so the profit allocated to the general partner’s carried interest will be taxed as long-term capital gains.
Folks are bothered by that, since the managers are often paying capital gains rates for doing what might be considered to be their job, which would normally be taxed at ordinary rates.
Most legal and economic analysis suggests that carried interest represents, at least in part, a form of performance-based compensation for services undertaken by the general partner. Although individual analyses differ slightly, there are two important themes with which most analysts concur. First, a general partner in a private equity or hedge fund undertakes a fundamentally different economic role from that of the limited partners, because the general partner is responsible (by virtue of his or her expertise, contacts and experience, and talent) for managing the fund’s assets on a day-to-day basis. Second, the carried interest is not principally based on a return to the general partner’s own financial assets at risk. If the purpose of the preferential rate on long-term capital gains is to encourage investors to put financial capital at risk, there is little reason for that preference to be made available to a general partner, whose risk involves his or her time and effort rather than financial capital.
But as a practical matter, the compensation contract and hedge fund structure could be revised:
Some observers view carried interest as a mixture of compensation for management services and capital returns. For example, one can think of carried interest as an interest-free nonrecourse loan from the limited partners to the general partner equal to 20 percent of the partnership assets, with the requirement that the loan proceeds be reinvested in the fund. (A borrower is not personally liable for a nonrecourse loan, beyond the pledged collateral, which in this case is the general partner’s claim on future profits.) To see how this example works, imagine a fund worth $100 million. With no direct capital investment, the carried interest entitles the general partner to the profits on $20 million (20 percent of the profits on $100 million is equivalent to the full profits on $20 million). It is therefore as if the limited partners have contributed $80 million to the fund and then lent the general partner $20 million to invest in the fund too, but without charging the general partner interest on that loan.
This implicit loan perspective would result in treating carried interest somewhere between purely capital income and purely ordinary income. In particular, under current tax rules, the implicit interest on an interest-free loan would be taxed as
ordinary income, with the interest rate set at the current rate on federal securities with the same duration as the loan. At the time the partnership sold its assets, any gain or loss to the general partner, after paying back the loan, would be treated as capital. In effect, then, this perspective would suggest that the component of carried interest attributable to implicit interest on the implied loan would be ordinary income and that the returns in excess of that implicit interest would be capital income.
If the hedge fund was actually structured (or re-structured) as described there would be little for Congress to fret about, unless they were planning to revise the entire section of the tax code dealing with partnership taxation.
Which implies that if Congress does "close" this loophole, hedge funds will restructure and the tax bill of the managers will be little changed.
Or so I say, anyway - a day may come when the WaPo (or more likely, the Wall Street Journal) takes up this issue as something more subtle than Congressman for sale.
MORE: If a friend or associate of Mr. Cohen is overcome by the desire to drop me the odd $50,000, don't be a stranger...
from your article...
Knock me over with a feather...
Posted by: RichatUF | November 07, 2007 at 05:55 PM
I'm never surprised when politicians sell their votes--what always shocks me is that they sell them so cheaply.
Posted by: Ralph L | November 07, 2007 at 06:31 PM
Here's how it's done with defense expenditures
Posted by: Patrick R. Sullivan | November 07, 2007 at 06:44 PM
"and $16,750 to Dicks"
Yeah, but what are their names?
I really can't think of anything much more futile than trying to make a hedge fund manager pay taxes. "Closing a loophole" to those guys is just an invitation to exercise creativity.
Posted by: Rick Ballard | November 07, 2007 at 07:34 PM
Speaking of taxes...aye caramba
Walter's donated to the DNC.
Posted by: Topsecretk9 | November 07, 2007 at 07:53 PM
This needs no introduction:
Posted by: Patrick R. Sullivan | November 07, 2007 at 08:12 PM
Well let's just see how far those donations to the "d's" goes.
As someone who has photographed Patty Murray in one of her moments of largesse--I can personally say I was not proud of trying to make her look good--but I did--and it wasn't easy.
Our US Senator delegation from WA state is an embarressment.
Posted by: glasater | November 07, 2007 at 08:41 PM
http://www.criticsrant.com/bb/reading_level.aspx
Posted by: jie | November 07, 2007 at 08:55 PM
Can somebody help me out?
I'm looking for the Edwards quote where he was asked if Bush lied on the Iraq war Intell, and he said "It's not the truth, but it's great politics."
It seems to have slid down the memory hole of the internet.
Posted by: Pofarmer | November 07, 2007 at 09:10 PM
Walter's donated to the DNC.
Did Not!
Harriette Walters
Oh.
Nevermind.
Posted by: Walter | November 07, 2007 at 09:59 PM
TSK9-
Walter's donated to the DNC.
Her pardon will be mailed Jan 21 2009-No worries.
Rick-
I really can't think of anything much more futile than trying to make a hedge fund manager pay taxes. "Closing a loophole" to those guys is just an invitation to exercise creativity.
Heh. I was reading the article and they donate 2/3 to Democrats. I suppose it must be nice to write up legislation and then knowing how to exploit it to maximize profit, can't wait. I also remember a while back when the .com bubble was puffing up that someone did a study of the financial investments of Congressman and it showed the outsized returns that some of them received [it dealt with some language that was slipped into the 1996 Telecom bill and all the companies that were able to exploit it].
Pofarmer-
The only other reference I found was one you made at this site back it Feb 07-did he make the comment back in 2004?
Posted by: RichatUF | November 07, 2007 at 10:17 PM
Rich,
The Friedman quote that Patrick brought to our attention should be on the wall of every voting booth. Congress earns its approval rating every damned day.
Posted by: Rick Ballard | November 07, 2007 at 10:39 PM
If the hedge fund was actually structured (or re-structured) as described there would be little for Congress to fret about, unless they were planning to revise the entire section of the tax code dealing with partnership taxation.
Which implies that if Congress does "close" this loophole, hedge funds will restructure and the tax bill of the managers will be little changed.
This is a bit too much like work--or this blog is getting more appealing.
All I can say is that the partnership tax laws are like the antitrust laws in that a few sentences generate pages and pages of regs interpreting congressional intent and court rulings. (In the cited section [704], some 2 pages generate over 100 pages of regs [1.704-1 - 1.704-4] at a similar type size.)
Which isn't to say that the good folks at hedge funds won't hire the best advocates money can buy, but Congress just needs to add a couple subsections to address this issue. The regs will run some 50 pages and will only be read by those of us who get paid to do so.
--
A few (well, many) years ago, the WSJ ran a piece on the Spring meeting of the Tax Section of the ABA. They discovered several lawyer/accountants hitting a local comedy club open mic night. One of the more popular aspiring comics spent his 15 minutes simply reading straight from the regs, with inflection and emphasis of particularly amusing phrases.
Posted by: Walter | November 07, 2007 at 10:44 PM
http://soccer.seniorclassaward.com/public/women/vote.aspx> VOTE JMax!
Tarheel teammates locked up in an out of town non interent ready hotel! She could use a little extra ummph today and tomorrow if you can pitch in.
Heels 3 Clemson 0 yesterday. Rematch Friday evening with Virginia.
Posted by: GMax | November 08, 2007 at 09:52 AM
I suspect the Diebold machine to be alternately assigning all votes to the two leading candidates.
=================================
Posted by: kim | November 08, 2007 at 10:19 AM
Gmax:
Heels 3 Clemson 0 yesterday. Rematch Friday evening with Virginia.
But wait! There's more!!!
I REALLY REALLY REALLY was bummed I couldn't make it to the game last Friday.
Really bummed.
Posted by: hit and run | November 08, 2007 at 03:11 PM