Most of the debate over carried interest
focuses on whether managers of hedge funds, leveraged-buyout
funds, venture capital funds and other private investment
partnerships are paying their fair share of taxes.
But if Congress changes the
carried-interest rules, they could affect investors in these
funds, as well.
Managers of these funds usually get paid
both a base management fee and a performance fee. The performance
fee is a percentage of the profits earned by the fund.
Many times, the performance fee isn't paid
in cash but instead is paid to the manager as an allocation of
profits, a “carried interest.” This method of payment can carry a
possible tax benefit both to the manager and indirectly to the
individual investors in the fund.
If a manager receives performance fees in
cash, the taxable income from that activity would be taxed to the
manager at his or her highest marginal tax rate on ordinary
income, up to 39.6%. If a manager instead takes his or her
performance fees as an allocation of profits, the taxable nature
of the income realized by the fund is passed through to the
If the fund earned all long-term capital
gains, all the manager's income from performance fees would be
taxed instead at long-term gains rates, or 23.8%.
Investment management fees paid by
individuals are miscellaneous itemized deductions. Many
high-income taxpayers can't deduct miscellaneous itemized
This is the case with any managed account,
as well as for investment partnerships. It applies both to the
base management fee and to any performance fees paid, not
The problem isn't present in funds that
have enough portfolio turnover to qualify as “traders” instead of
being taxed as “investors.”
There is nothing anyone can do about the
base fee being a “useless” deduction. However, if the performance
fee is a carried interest, then it is thought that the cost of the
performance fees are no longer miscellaneous itemized deductions.
Instead, these allocations lower the
taxable income flowing through from the fund to the investor. Thus
the manager's choice of a carried interest instead of a cash fee
also helps investors.
So what are the ramifications if Congress
finally passes carried-interest legislation?
The increased tax burden will fall most
heavily on managers of partnerships whose profits are composed
chiefly of long-term capital gains. Their tax rate would go from
23.8% to 39.6%, up from last year's 15%.
The effect on a hedge fund manager's tax
bill would depend on the taxable nature of the income the fund
earns. The 3.8% Medicare tax is imposed only on investment income,
not on ordinary income.
Performance fees that a manager receives in
cash are taxed at 39.6%. Performance fees earned on short-term
gains allocated through a carried interest are taxed at 43.4%.
One Big Four accounting firm has suggested
that managers of “investor” hedge funds consider giving up carried
interest to avoid the 3.8% tax and not bother waiting to see what
happens in Washington.
If the income of a fund is predominantly
interest and short-term gains, we would agree with that logic. Why
should the manager pay 43.4% instead of 39.6%?
If carried-interest legislation is passed,
it might make sense for all investment partnerships to go to a
cash fee. The problem created is that the investor could wind up
with more “useless” miscellaneous itemized deductions stemming
from a cash performance fee and a tax bill on phantom profits.
Hedge funds that trade enough to be
classified as “traders” have been spared the phantom income
inequality because they are allowed to deduct the fees before
calculating taxable income. A lot rides on whether a fund is a
“trader” or an “investor,” and thus this issue belongs in the
due-diligence questionnaire of any taxable-hedge-fund investor.
The 3.8% Medicare tax is meant to be
applied only to net investment income. There would be major
inequitable distortions if taxpayers, especially rapid-turnover
traders, had to pay 3.8% on their gross gains instead of their net
But if you work your way through the
proposed regulations implementing the Medicare tax, that is
exactly what would happen to investors in a “trader” fund. It
seems that there is nowhere to hide.