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Debunking today's carried interest tax arguments

April 10, 2013: 4:58 PM ET

obama-stimulus'Carried interest' is back on the table and so are the private equity industry's defenders.

FORTUNE -- President Obama today unveiled his federal budget proposal, which included a change to how private equity fund managers are taxed on investment profits (i.e., carried interest). Basically, it would tax carried interest as ordinary income, rather than at the lower capital gains rate. And, to be clear, this only relates to gains where the original money was invested by third parties (endowments, pension funds, etc.). Any money risked by private equity pros themselves would remain taxed as a capital gain.

Obama's proposal was expected, given that he has publicly supposed such a change since first running for president. Also, as expected, specious arguments are being used to defend the status quo.

So what follows is a rundown and obligatory debunking. If you're looking for my more general argument for why Obama is right, go here. It's from 2011, but the underlying issue remains the same. I also received a lot of critical feedback from that piece, and dealt with it in a follow-up post.

Without further ado, some of what we've already heard today:

1. Pam Hendrickson, COO of private equity firm The Riverside Co., authored a WSJ op-ed titled Think Twice Before Raiding Carried Interest.  In it, she wrote:

"From where I sit, any policy that ensures that capital can flow freely to businesses seeking to grow and create jobs is crucial."

From where I sit too, but there is no indication that a change to carried interest taxation would affect the free flow of capital. First, not a single private equity or venture capital investor has ever pledged to quit if this change is enacted (and I've asked my daily email readership, which includes thousands of these folks). More importantly, the data doesn't support her claim. Capital gains tax rates for top earners increased on January 1, 2013 -- but private equity investment basically doubled between Q1 2012 and Q1 2013. If higher tax rates decrease the free flow of capital, why is capital flowing even more freely with a higher tax rate?

Arbitrarily treating partners differently based on the type of contribution they make would set a dangerous precedent in the tax code that favors financial contributions over the contributions of entrepreneurial know-how and sweat equity.

Private equity itself often favors the value of financial contributions over the contributions of "entrepreneurial know-how and sweat equity." For example, imagine two firms team up on a deal, with Firm A contributing 20% more capital than the other. Firm B, however,  becomes more active on the board, works harder on recruiting executives and comes up with most of the ideas that drive future growth. Guess what happens when it's time to split the profits? Firm A gets 20% more than Firm B. Why? Because profits are based on financial contribution.

It would also ignore the inherent risk associated with buying and selling companies. A carried interest is worthless if the fund doesn't turn a profit. And, in many cases, carried interest is subject to a claw-back provision that requires money be paid back to the fund if the limited partner investors do not receive a target level of return on their investment.

If a fund doesn't turn a profit, what exactly has the private equity fund manager risked and lost (except, perhaps, his reputation and subsequent ability to raise future funds)? Again, remember that we are not talking here about a fund manager's personal contributions. As for the clawbacks, what Hendrickson fails to note is that they "money to be paid back" is from profits on other deals within the same fund. In other words, if all of a fund's investments are losers -- then the limited partners do not get to dip into the fund manager's pockets.

2. John Carney, writing for his CNBC blog:

The Obama administration proposes to tax carried interest as ordinary income. It's been argued by many people over the last several years that because the managers receive carried interest as part of their compensation for running the fund, it is equivalent to income. 

This isn't a totally implausible argument. But just because it makes some sense doesn't mean changing the tax treatment will actually mean fund managers will pay ordinary income taxes on their share of the profits. It is incredibly easy to get around a tax on carried interest just by changing the way the compensation is structured.

Yes, certain private equity funds will find a way around the new regulations. Already some of them dodge taxes on their fee income, by transferring it directly into the fund (and then taking carried interest on the profits). But since when did choose not to write laws because some people may find a way around them? More importantly, capital gains tax rates have yo-yoed over the past 15 years, but we have not seen much change in fundamental private equity fund structure. If fund managers are asked to pay more in taxes, they typically do it. And if asked to pay less, they certainly do that too.

3. More Carney, this time via Twitter:

Capture

I almost choked on the word "punishes," since it implies that private equity executives are being asked to pay a different rate on their income than are others in their tax bracket (they aren't). But let's deal with Carney's main point, which is that Obama is rewarding those with means to risk their own capital without offering a similar reward to those who help manage such risk (i.e., fund managers).

First, encouraging investment is the whole purpose of capital gains. By following Carney's logic, poorer folks should pay a lower tax rate on investment gains than should richer folks. He's not arguing for equality -- he's arguing, apparently, for progressive capital gains. Hadn't heard that one before.

Second, and most importantly, Carney ignores the fact that private equity pros don't necessarily raise outside money out of necessity. They do it to lower their own risk. Kohlberg Kravis Roberts & Co., for example, have spent well over a year trying to raise $7 billion or so for a new North American buyout fund. But Henry Kravis and George Roberts have a combined net worth in excess of $8 billion, according to Forbes. Not sure how much of that is liquid, but they theoretically could contribute much more to the fund than the industry standard 1%-5%. Raising money from others isn't always "need." Sometimes it's choice -- a choice that lowers the very risk that capital gains rates exist to reward.
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This is also the part where I note my complete and utter lack of faith that the tax treatment of carried interest will actually be changed. It works too well as a political football for both sides, and too many liberal Democrats come from states that house most of America's private equity executives. But such practical matters shouldn't get in the way of a good argument.

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About This Author
Dan Primack
Dan Primack
Senior Editor, Fortune

Dan Primack joined Fortune.com in September 2010 to cover deals and dealmakers, from Wall Street to Sand Hill Road. Previously, Dan was an editor-at-large with Thomson Reuters, where he launched both peHUB.com and the peHUB Wire email service. In a past journalistic life, Dan ran a community paper in Roxbury, Massachusetts. He currently lives just outside of Boston.

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