Wednesday, April 14, 2010

Putting an end to a capital idea

Gain on stock are generally treated as capital gain. But not when the gain is from stock given as compensation for services. Then it's ordinary income. (That is an oversimplification because of the rules put in place to try to change the character back to capital in the years since stock options have become such an integral part of some paychecks.)

Ordinary "income" from your wages and other service compensation has traditionally been taxed at higher or less concessional rates than "profits" from capital assets. It's one of the ways the rich get richer.

Interest income is also taxed at ordinary rates, but interest paid to purchase capital assets is deductible from ordinary income received. (Again, oversimplified to ignore numerous anomalies.)

With that basic notion of the difference between tax treatment of capital and income, consider this:

Managers of investment partnerships typically are paid 2 percent of fund assets as an annual management fee and 20 percent of the profit earned for investors above certain levels. While the management fee is taxed as income, the share of profit, known as carried interest, is treated at the capital- gains rate

Seem fair to you?

The spin given in this article, starting with its title, clearly seems to want you to. Pay attention to the fanciful use of italicized words.

Senate Considers Tax Rise on Buyout-Firm Managers, Schumer Says
The U.S. Senate, seeking funds for jobs bills and other initiatives, will consider adopting a House proposal to more than double tax rates on executives at private- equity firms, said Senator Charles Schumer, a New York Democrat. [This is not a rates issue, it's a characterization issue. And it's not a tax on executives, but on the compensation they earn from their services.]

The proposal, projected to raise $24.6 billion over a decade, would affect venture capitalists, managers of real- estate partnerships, and hedge-fund managers who make long-term investments. [It is not an investment, it's deferred income, based on the investors' income. These guys just make and manage the investment for a fee. Real estate agents who manage property for other owners also get a percentage of the rent due under the lease, which is taxed as ordinary income.]

Democrats in Congress need to tap new sources of revenue for any spending after the passage last month of the $940 billion health-care bill. [This tries to make it seem an unfair grab to underwrite what some keep wanting to portray as a grubby health bill. No one mentions how unfair it was that this scheme was allowed to go on in the first place.]

“Even though the measure doesn’t produce a lot of revenue, it’s good economic policy,” Geithner said at the time. Investment managers shouldn’t be paying less in taxes than firefighters, he said.

Senate Finance Committee Chairman Max Baucus, a Montana Democrat, said through a spokesman in December that he wanted to address the carried-interest issue in the context of a broader overhaul of the tax system. [Wolves up in Montana know that the first thing you have to do to get a kill is to cull the prey from the herd.]

Buyout managers are getting back to business after the global credit crisis that began in 2007 prevented them from buying companies or selling assets. About $14.2 billion worth of private-equity deals have been announced in 2010, compared with $3.36 billion in the same period a year earlier, according to data compiled by Bloomberg. [Private equity buy out managers were a contributing cause of the credit meltdown. See here and here, etc.]

John Chapoton, a partner at Brown Advisory in Washington who served as a top tax-policy official under President Ronald Reagan, said both venture capitalists and buyout firms are defending an undeserved tax break.

“Capital-gains rates are meant to encourage investment of risk capital; there is no capital placed at risk when a carried interest is received for services rendered,” Chapoton said.

“The preferential treatment of carried interests would not be in the law except for an historical anomaly, and its repeal would not warrant any thought on the Hill but for large campaign contributions.” [Amen to that.]

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