Big tax break depends on difference between being investor and being businessman

January 7, 2012

Todd Dagres, a prominent venture capitalist and independent movie producer, earned $3.5 million in 2003 and paid not a cent in federal income tax.

The IRS challenged the math and sent Dagres a bill for $981,980 in back taxes, plus $196,369 in penalties.

Dagres lawyered up. His attorneys waived one lucrative tax break to exploit an even better one and claimed victory in the case in March.

In the course of the dispute, Dagres offered five years of his tax returns as evidence in U.S. Tax Court. His testimony, tax forms and other documents offer a rare glimpse of how wealthy Americans work the angles to keep from paying taxes.

Dagres earned $58.5 million over those five years — ranking him among the richest 0.1 percent of Americans. During that stretch, the statutory rate for taxpayers in his income bracket was as high as 39.6 percent. But because of an array of tax breaks, Dagres paid 20 percent on his total income.

Dagres, 51, is not alone. Although American working families earning less than $100,000 pay, on average, about 35 percent of their taxable income in payroll and income taxes, their wealthier counterparts — those who earn more than $1 million a year — pay less than 30 percent.

The trend has grown pronounced in recent years, especially for the very, very rich who, like Dagres, earn most of their income from investing and can exploit the low rates on capital gains. The average tax rate for the 400 wealthiest Americans was 29.3 percent in 1993 but dropped to 18.1 percent in 2008, according to the latest IRS statistics.

During that time, the combined taxable income of the top 400 soared from $16.3 billion to $91 billion. The richest 10 percent of Americans now control 70 percent of the country’s wealth.

In an era of rising income inequality, mammoth budget deficits and proposed cuts in defense and federal assistance programs, the taxes paid by rich folks such as Dagres are a topic of national debate. Dagres did not respond to repeated requests for comment.

Billionaire Warren Buffett fueled the controversy when he publicly deplored that his office receptionist and other employees pay taxes at higher rates than he does. Buffett didn’t release his tax returns, but he said his annual tax rate, including payroll taxes, is 17.4 percent.

In America, federal taxes are “regressive,” the Congressional Research Service reported in an October study. “The average tax rate decreases as taxable income increases.”

Wrinkles in the tax code

At the heart of the Dagres case is a $2 billion-a-year wrinkle in the tax code known as the “carried interest” tax break. It permits wealthy hedge fund operators, venture capitalists and other private-equity managers to treat their pay, for tax purposes, as a return on an investment instead of as a salary.

By doing so, they pay taxes at the 15 percent capital gains rate instead of the 35 percent rate on ordinary income.

“This nonsensical loophole is deeply unfair at a time when working families are struggling,” said Sen. Carl Levin (D-Mich.) in a Senate speech in June. “If you are a hedge fund manager, your job is to manage a hedge fund. The income you receive for that job is no different than the income a waitress receives for waiting tables or a janitor receives for scrubbing floors. The idea that the income of millionaire fund managers should be taxed at a lower rate than that of their staff or other workers is an absurdity.”

After graduating from Trinity College in 1982 and picking up a master’s degree in business at Boston University, Dagres joined and prospered in the fast-growing financial services industry. He was one of thousands of bright young Americans lured to the sector, which more than doubled its share of U.S. corporate profits since 1980, from 15 percent to a high of 33 percent in 2003.

The capital in the private-equity market — where managers raise funds to buy or invest in new and existing businesses — soared from roughly $5 billion to $1 trillion in this period. At the same time, thousands of new hedge funds — private entities using complex trading strategies — sprang into existence, managing another $1 trillion.

On Wall Street, firms increasingly focused on the creation, sale and trading of complex financial products. Bonuses and other compensation soared — the average almost doubling that of the nonfinancial sectors in the U.S. economy.

Midas touch with venture capital

As a venture capitalist, Dagres fulfilled a classic economic purpose, raising money from investors to bankroll entrepreneurs and incubate new firms. The rewards could be spectacular: In 2000, Dagres earned $44 million while a partner in a Boston venture capital firm, Battery Ventures. He had a network of knowledgeable sources in the booming tech sector and a keen eye for talent and a promising idea.

Dagres was an early investor in Twitter and struck gold with hot new firms such as Akamai Technologies and Qtera. In the Qtera deal, he later told the Tax Court, he made $800 million for his investors off a $15 million investment. He was listed on the Forbes “Midas” list of the top venture capitalists in America and branched off into the movie business as a producer of the films “Transsiberian” and “Pretty Persuasion.” The vanity license plate on his luxury Mercedes S55, the Boston Globe reported, read “VENCHA.”

The compensation plan at Battery was typical of private-equity firms. Dagres acted as a “general partner.” He would work his sources, spot an opportunity, conduct research and solicit money from wealthy clients, who came together as “limited partners” in a venture he managed and administered. Battery collected management fees, big enough to give Dagres a multimillion-dollar salary, but the big payoff came if the investment succeeded. Then Dagres and his firm would get 20 percent — the “carry” or “carried interest” — of the profits.

“It’s a performance-based business,” Dagres told the court, when his case came to trial in 2009. “If we perform well, we’re compensated well. If we don’t perform well, we’re not.”

The treatment of carried interest is a legacy of 20th-century partnership law, crafted with small businesses in mind in the years before the financial services industry became a behemoth. Today, it represents a loss of tax revenue. Closing the carried interest loophole would yield $20 billion during the next decade.

It saved Dagres hundreds of thousands of dollars. In his 2000 tax return, Dagres listed $40,579,415 in capital gains and $3.6 million in salary, interest and dividends. The Bush tax cuts, which cut the capital gains tax from 20 to 15 percent, had not yet taken effect, so his total effective tax rate was 21 percent — about that of a middle-class family.

A political and lobbying force

Defenders of the carried interest tax break say that the work of hedge-fund managers and other investment managers, in raising and allocating capital, makes a vital contribution to the American economy. Eliminating the tax break “would likely inflict large damage on the finance, insurance and commercial real estate sectors, diminish their entrepreneurial talent pool, and harm overall economic efficiency,” said Douglas Holtz-Eakin, a former congressional budget director, in a paper for the American Action Forum, a pro-business group led by prominent Republicans, in 2010.

When the Obama administration and members of Congress tried to do away with the carried interest loophole in the wake of the 2007-08 financial crisis, the financial services industry fought back and prevailed, and has continued its resistance even as lawmakers cast about for potential sources of revenue during the ongoing federal budget debate.

The industry is a political and lobbying juggernaut on Capitol Hill. Over the past two decades, the finance-insurance-real estate sector, whose principals are the most likely to profit from the carried interest tax break, has been the single leading source of campaign funds for federal candidates, according to the Center for Responsive Politics. Donors from the sector have given more than $2.7 billion in that period to candidates for Congress and the presidency, favoring Republicans by a 55 to 45 percent ratio.

And when it comes to lobbying, the financial sector shares the lead with the health-care sector, each of which has spent more than $4.7 billion lobbying in Washington since 1998, the center said.

In the Senate, the Democrats from New York and Connecticut have faithfully represented, and been rewarded by, their Wall Street constituents. New York Sen. Charles E. Schumer has raised $18.7 million from the financial sector during the past two decades, while former Connecticut senator Chris Dodd, who helped write the latest financial regulatory legislation, collected almost $14.5 million.

The giving persists in the current election cycle, according to the Center for Responsive Politics, with more than $135 million donated to candidates and groups for the 2012 elections. Topping the list of individual donors are familiar, politically well-connected firms such as Goldman Sachs (having given $2 million) and Bain Capital (with almost $1.8 million in donations).

In the House, the financial sector has strong ties to the Republican leadership. Speaker John A. Boehner (having collected more than $1.2 million in the 2012 cycle), Majority Leader Eric Cantor ($903,000), Majority Whip Kevin McCarthy ($455,000), GOP Conference Chairman Jeb Hensarling ($525,000) and House Ways and Means Committee Chairman Dave Camp ($527,000) are favorites of the industry.

Cantor, who has collected $5.8 million — more than any House leader — from the financial sector in 12 years, is a champion of the carried interest tax break. His wife, a former Goldman Sachs vice president, works as a partner in a Wall Street private-equity fund.

“If the deal goes bust: No money,” Cantor said, defending the carried interest tax break in September. “If the deal is successful, there is a return, [and] you pay the capital income tax. . . . I think that the capital gains tax . . . distinguished from ordinary income, is the essence of what we believe is an entrepreneurial-based, free-market economy. We want to provide incentives for investors and entrepreneurs to put capital at risk so we can create jobs.”

But critics of the loophole ask why a fund manager should be given the same low tax rate as an investor, who shoulders the risk of losing money and puts up the actual cash.

Lawyers who work for contingency fees don’t get a carried interest tax break. Nor do Hollywood actors who take a piece of the box office for their performance in a motion picture. Nor do authors or songwriters who rely on royalties. Nor do professional athletes, whose contracts include performance-based incentives. Nor do other business executives, whose compensation packages may include performance bonuses and stock options. Nor do bankers, stockbrokers or financial planners.

“Most economists . . . would view at least part and perhaps all of the carried interest as performance-based compensation for management services,” then- congressional budget director Peter Orszag told Congress in 2007. It should be taxed, therefore, “as ordinary income, as most other performance-based compensation is currently treated.”

A bigger, better loophole

In a startling turn, with potentially far-reaching effects for the hedge fund and private equity industries, Dagres joined the critics of the carried interest loophole in 2003. When a business deal turned sour and his financial circumstances changed, Dagres and his lawyers found it preferable to argue that carried interest was indeed mere compensation — and not an investment. The venture capitalist, in effect, sought to have his cake and eat it, too.

The triggering event was the dot-com crash of 2000. One of the biggest and most spectacular casualties was William Schrader, pioneering chief executive of PSINet, who was known as “the father of the commercial Internet” for the fiber-optic network and Web-hosting centers that he built. Overextended, with his company collapsing around him, Schrader asked Dagres for a loan. The two had done business throughout the Internet boom years, trading information and sharing prime investment opportunities.

“It was very hard for me. I don’t ask people for favors,” Schrader told the Tax Court. “But I did it. And I told him it was hard. And he said that I could count on him for $5 million.”

Dagres was motivated by more than friendship. “I had spent a lot of time and effort building him up into a significant resource,” Dagres testified. “I didn’t want to lose him. . . . I felt that, if I loaned him the money, he would be indebted to me. . . . I was also concerned that somebody else might make the loan and gain his favor. I never imagined that he wouldn’t have $5 million to pay me back.”

But the loan didn’t save Schrader, and as time passed, he found it difficult to keep up with the payments he owed to his friend Dagres. In August 2003, lamenting in an e-mail that he could not “keep working under the emotional weight of the unpaid and unresolved loan,” Schrader asked whether there wasn’t a way for Dagres to forgive the remaining balance — more than $3.6 million.

Perhaps Dagres “can use the tax write-off,” Schrader said. He would give Dagres first shot at good deals in the future, he vowed. “This is just a rationalization, of course,” he said, “so that I don’t feel guilty that I end up becoming a pile of mush.”

Dagres agreed to forgive the $3.6 million, and his accountants and lawyers went to work to deduct the loss as an ordinary business expense. To reap the maximum write-off for the bad loan, his lawyers had to reposition Dagres as a businessman, not an investor. And here they faced a significant hurdle: The IRS, under the carried interest theory, had been giving Dagres the cut-rate treatment due an investor.

In 2000, because his income was taxed as a capital gain on an investment and not as ordinary business income, Dagres had saved $7.9 million in federal taxes, the IRS said. He couldn’t have it both ways. “These activities are all investment activities and earned petitioner and his colleagues investment returns,” the government said. “Investing is not a trade or a business.”

The government hit Dagres with a $1.1 million bill for back taxes and penalties. He decided to fight it in court.

Winning over the judge

Dagres was a “professional,” not an investor, his lawyers contended. He was in a competitive business and was paid “for the many services” he performed for the real investors. He was working just like a lawyer, for a contingency fee.

“A carry can be fantastically lucrative,” his lawyers said, but “none of this gain was attributable to petitioner’s own invested capital.” The risk had been borne by his “customers.”

“Professional venture capitalists are service providers,” lawyer Joel Carpenter said when the case was heard in June 2009. The carried interest was merely compensation. “It’s that compensatory element, in the absence of significant personal investment, that distinguishes his business from the activities of an investor.”

Carpenter was persuasive. Dagres won his case and paid no back taxes or penalties. But the ruling by U.S. Tax Court Judge David Gustafson must have sent a shiver through many a hedge fund manager, because it buttressed the arguments made by critics of the carried interest loophole.

Money management was a business, the judge declared, and the gains and losses could be treated as ordinary income. The decision seemed to open a door: Might the IRS or another federal judge reclassify the gains of carried interest as ordinary business income, subject to a higher rate of taxation?

“An activity that would otherwise be a business does not necessarily lose that status because it includes an investment function,” Gustafson wrote. “Bankers, investment bankers, financial planners and stockbrokers all earn fees and commissions for work that includes investing or facilitating the investment of their clients’ funds. Selling one’s investment expertise to others is as much a business as selling one’s legal expertise or medical expertise.”

$11.8 million

The total taxes Todd Dagres paid on the $58.5 million he made from 1999 to 2003. Dagres was filing as an investor and he claimed capital gains benefits, so he paid 20 percent in taxes on his total income. In that stretch, the statutory rate for taxpayers in his income bracket was as high as 39.6 percent.

$23.2 million

The estimated amount Dagres would have paid in taxes if he filed as a businessman and paid the 39.6 percent rate during those years. In this scenario, he couldn’t have claimed the “carried interest” tax break, which let him treat his pay, for tax purposes, as return on an investment instead of as a salary.

Investor

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Todd dagrese

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