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."
Levin and some other lawmakers disagree, however, saying there is good reason to treat those earnings as regular income, regardless of decisions by the IRS and its overseer, the Treasury Department.
"The Treasury Department has looked at this as part of its regulatory responsibilities," Levin said. "But that shouldn't constrain Congress from acting to make the tax code more effective and equitable."
Private-equity firms are a relatively recent innovation on Wall Street, having come to prominence over the past two decades. Unregulated by the Securities and Exchange Commission, they amass huge amounts of money from wealthy individuals, pension funds and financial institutions, and use it to buy companies, such as Chrysler and the Hilton hotel chain, two recently announced deals.
Hedge funds are similar in that they pool money from large investors, but they often trade in stocks and bonds that provide financing for corporations.
The highly skilled, hyper-aggressive people who run private-equity firms and hedge funds put some of their own money into the pot, but nowhere near the sums contributed by the other partners, whose profits are taken as capital gains -- that is, returns on their investment of capital.
Instead of money, the managers contribute primarily their expertise to the venture. They raise the money, select the buyout targets and work to make the companies profitable. For that, they are typically rewarded with a 2 percent annual management fee and a 20 percent share of profits when the firm's portfolio of companies is sold, an arrangement known as "2 and 20." The 20 percent profit share is called the carried interest, and private-equity managers treat it as a capital gain.
The debate raging on Capitol Hill revolves around whether managers should continue to claim the payout as a capital gain as the other partners do, or whether they should characterize it instead as compensation for labor.
If the payout is just another partnership share, then the lower capital gains rate would apply. But if the payment is for services rendered, then the higher, ordinary-income tax rates would apply, as they do for the management fee.
No one disputes that the Carry and its tax rate are supported by long legal precedent. The IRS accepts it not only for private-equity managers but also for managers of other kinds of partnerships that deal in capital assets, such as securities, commodities and real estate. Profits from the sale of those assets are almost always taxed as capital gains, a benefit designed to encourage risk-taking by money managers.
But the law makes no distinction between investment partners who contribute money and managing partners who contribute labor. For decades, a debate has raged among tax lawyers and academics over when and how to tax partners who are awarded shares of the profits primarily in exchange for their services.
The matter was first directly raised by the case of Sol Diamond, an Illinois mortgage broker enlisted to secure financing for a building in 1962. A partner provided cash, Diamond delivered a bank loan, and the pair agreed to split the eventual profits. Three weeks later, Diamond sold his interest in the deal for $40,000, which he and his wife, Muriel, claimed as a short-term capital gain.
The IRS objected, arguing that Diamond was made a partner in the deal as payment for his services and that the value of his right to share in the profit should be taxed as ordinary income. In 1971, the courts sided with the IRS in a ruling that launched a long period of hand-wringing but was widely ignored.
Twenty years later, a tax court issued a similar opinion in another case, which was quickly overturned on appeal. Since then, the IRS has tinkered on the edges of the issue. The agency declared in 1993 that the award of a profit share to a partner in exchange for services would not be immediately taxed.
But neither the agency nor the courts have addressed the question at hand: When the profits eventually do roll in, should the service partner be taxed in the same way as the investors?
University of Texas law professor Mark P. Gergen, who has written in favor of changing the Carry's tax status, said that until now, "nobody has been focusing on the fact that if you're contributing services to a partnership where the returns are capital gains, you've managed to convert ordinary income to capital gains."
Advocates of change say there is ample reason to identify the Carry, or at least most of it, as a wage. It is, after all, not a return on invested money. It is the product of work done to help a venture succeed, in much the way that an assembly-line employee helps a company make cars or airplane parts, they say.
"These investment managers are being paid to provide a service, and fairness requires they be taxed at the rates applicable to service income just as any other American worker," Levin said.
Defenders of the current system say Levin misreads the situation. They say managing partners are not employees, but bosses, deserving of the capital gains income that flows through the partnership because they are largely responsible for creating it.
"The general partner should be treated as the owner-proprietor because he raises the capital from the other partners and controls all decision-making," said Jonathan Talisman, a lobbyist retained by the Private Equity Council, the trade association of the private-equity industry. "We reward this type of entrepreneurial risk-taking and investment in long-lived assets with favorable capital gains treatment."
Congressional tax-writing committees plan to tackle the Carry this fall and to consider the narrower Senate bill that would force publicly traded private-equity firms and hedge funds to pay taxes at the 35 percent corporate rate.