States continue the fight on carried interest tax

The battle over carried interest tax at state-level rests on whether it is seen as a reward for labor or for risk.

“The hedge fund guys are getting away with murder.” This was Donald Trump’s characterization, during his presidential campaign, of managers paying 20 percent tax on carried interest rather than the then top income tax rate of 39 percent.

But the action he took as president was weaker than many expected, given his campaign trail rhetoric. Rather than tax carry as ordinary income, the 2017 federal tax reform act extended the amount of time a manager, including those in private funds, must hold an asset before it can be treated as a long-term capital gain and taxed at 20 percent. Any gain less held for less than three years will be taxed at the new ordinary income tax rate of 37 percent.

“It was really a gift to the industry,” one tax lawyer who didn’t want to be named tells pfm. “It could have been a lot worse.”

Donald Marron

Donald Marron at Washington DC think-tank the Urban-Brookings Tax Policy Center says the change “suggests the current treatment of carried interest is more stable than we thought. We thought there would be more aggressive restructuring of the way carried interest is treated and were surprised by how little was done.”

The tax treatment of carry rests on one world-view – that carry is a reward for entrepreneurial risk – over another – carry as compensation for labor. Through the Obama years and into Trump’s term, it appeared that the position that has dominated for years – carry as reward for risk – was weakening.

“There is no intellectually defensible reason to tax ordinary income as capital gains merely because that income was generated by managing someone else’s money rather than cooking French fries,” says Morris Pearl, former BlackRock managing director and head of the Patriotic Millionaires group.

Pearl, whose organization campaigns for what it believes would be fairer taxes on high earners, tells pfm that “this one group of people make the ridiculous claim that because of their business structure they should pay tax at the same rate as their clients [limited partners]. They claim they are not working, but that they are partners of their clients and should pay the same rate.” But carry as reward for risk has a sticky grip, persuading lawmakers and successive presidents.

“GPs are providing services and there is no guarantee they are going to get paid. The entrepreneurial risk is that they won’t make a large enough return to get into the carry. With carried interest there is no guaranteed upside. It is different from a management fee in that regard,” says Michele Itri at New York law firm Tannenbaum Helpern Syracuse & Hirschtritt.

A large European LP tells pfm he was similarly minded. “The fund is not producing income. The IRR being generated by the fund is a capital gain on investment, not compensation for labor.”

But some states find Pearl’s view more persuasive. In February California became the eighth state (ninth jurisdiction, including Washington DC) to introduce a proposal to tax carried interest at higher rates. It would see income from carry taxed at 17 percent in an effort to “top up” the 20 percent federal capital gains rate and align carry with the 37 percent top federal income tax rate. Other state proposals prior to the federal tax bill sought to align with the old 39 percent income rate.

But Itri sees a problem: “States will be hard pressed to find the authority to tax one stream of income higher than another stream of income. It’s over-reach by states. If they were to try, they would be open to lawsuits by managers.”

However, Itri says she could see carried interest being treated as a payment for services.

“In a jurisdiction like New York City that does tax things like performance fees – which are subject to New York City’s 4 percent unincorporated business tax – I could see the authorities saying carry is payment for services.” Lost, for the most part, in the current debate are the LPs who pay general partners carry through the return on their capital.
“To tax carried interest just right, it should be labor income for managers and deductible against ordinary income for investors,” says Marron.

He says this approach would direct the favorable tax treatment of capital income to the LPs who bear the financial risk but protect the usual tax benefits for capital gains and dividends. This approach is not without its problems, as the European LP says: “A potential concern is that the GP comes back [to me] and argues for a higher carry rate because he didn’t make enough money after tax.”

Marron accepts this is an issue. “In a hypothetical world of only taxable LPs, my proposal implies that fund managers would raise carry or management fees to offset increased taxes, and taxable investors would get a larger deductible expense. If investors could fully deduct carry and fees, it would be a wash. In the real world, many LPs are tax-exempt. If you tax carry as ordinary income, some GPs will raise their carry or fee to compensate. Tax-exempt LPs won’t get a corresponding benefit from an increased tax deduction. So it’s a reasonable concern that taxing carry as ordinary income would come back to LPs in higher net fees.”

However, he has less time for the idea that firms would shift states if carry taxes were imposed. “There are already significant differentials between states’ tax regimes, including some states that don’t have an income tax, and we don’t see that much movement.”
What are the chances these state-led efforts will succeed? In California the Democrats recently lost their congressional super-majority, which is likely to slow progress.

Meanwhile, on the East Coast, eyes are on Pennsylvania, which must first table its own bill before those in other neighboring states could take effect. Before then, all face significant challenges in their respective state legislature committees.

Itri says a wait-and-see approach by the states is most likely. Private funds managers will have to wait in turn to see if a first mover emerges.