Wall Street's Lucrative Tax Break Is Under Fire

By Jeffrey H. Birnbaum and Lori Montgomery
Washington Post Staff Writers
Friday, August 3, 2007

The most controversial tax break on Wall Street, known simply as the Carry, is not authorized by any law and was never approved by Congress.

Instead, it grew quietly over several decades, hinted at but never directly addressed in obscure court cases and arcane regulations issued by the Internal Revenue Service.

Unchallenged by lawmakers, it swelled into a benefit that, by one back-of-the-envelope estimate, spares a small band of the country's richest and most powerful financiers $6 billion a year in personal income taxes.

The astonishing cost of this tax break to the federal government has riveted attention on Wall Street's titans of the moment, the extraordinarily wealthy managers of private-equity firms and hedge funds. Until now, they have gone largely unexamined by Washington. But at a time of rising income inequality and with Congress engaged in a desperate hunt for cash to expand aid to a disgruntled middle class, the Wall Street money men have become an appealing target for Democratic lawmakers and presidential candidates, who say the financiers are woefully undertaxed.

At the heart of the dispute is the way the fund manager's profits are taxed. Known as carried interest, or the Carry, those profits are taxed as capital gains, for which the rate is usually 15 percent. That is less than half the 35 percent rate paid on regular income.

The Carry came into focus when private-equity firms, also known as buyout firms, recently began to sell themselves to the public. The transactions forced the firms, which are lightly regulated, to disclose how much their managers earn. The amounts were staggering. Last month, when Blackstone Group, the nation's largest private-equity firm, completed its initial public offering, co-founder Stephen A. Schwarzman pocketed $684 million.

Lawmakers were not only dazzled by the amount but also disgusted by how little Schwarzman and other private-equity managers pay in taxes.

The AFL-CIO expressed its outrage to members of Congress. The labor group complained that private-equity managers, many of whom live lavishly, were paying lower tax rates than firefighters and janitors. Even billionaire Warren E. Buffett, the third-richest person in the world, said it was wrong for him to pay a rate lower than the rate paid by his $60,000-a-year secretary.

Several key Democrats, led by Rep. Sander M. Levin of Michigan, attacked the Carry as an unfair tax break that Congress would never have granted. He is pushing a bill that would subject it to a higher tax rate, the one paid by ordinary taxpayers.

In response, private-equity firms have hired an army of tax lawyers and lobbyists to block the legislation, and a companion bill in the Senate that would boost taxes on private-equity firms that go public. They contend that the Carry, and its characterization as a low-taxed capital gain, has been common practice for years and accepted by the IRS.

Changing it, they say, would be a radical departure from accepted partnership law that would harm not only buyout firms but also partnerships in other major industries, such as real estate and oil-and-gas drilling.

Private-equity executives say they never dreamed that the tax status of their payouts would be questioned. "I don't think that anybody felt it would ever be challenged," said Scott M. Sperling, managing director of Thomas H. Lee Partners, a private-equity firm. Managers' earnings are "capital gains in every technical and spiritual sense."

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