Hedge funds and private equity have been two sectors of the economy talked about lately in the media and among politicians. When it comes to the tax code, some would argue that hedge fund managers and private equity managers have an extraordinary tax advantage because of something called “carried interest (defined later).” Because hedge fund managers can make more in a year than many people will ever see over the course of their entire lifetime, and since a large percentage of their income is taxed as capital gains, they have been under scrutiny over the last 10-15 years because of the growth of private equity and hedge funds.
What Are Hedge Fund Managers?
A hedge fund manager is basically a consultant who helps people make larger returns on their investments. Hedge fund managers claim to be able to reduce risk and bring in profits. Hedge fund managers are typically paid in two ways. First, they typically receive a 2% management fee. They also get what is considered a performance fee of 20% on any profits they earn their clients.
What Is The Tax Advantage Critics Point to With Hedge Funds?
Hedge Fund Managers typically abide by the 2 and 20 rule which means a 2% management fee (2% of the principal fund balance) is collected a year and the “20” refers to the 20% percent share (can vary) of the profits the fund receives. Generally, the 2% fee covers the fund's expenses so a substantial part of a hedge funds managers profit is “carried interest” which is defined according to Wikipedia as “share of the profits of an investment or investment fund that is paid to the investment manager in excess of the amount that manager contributes to the partnership.”
Hedge fund managers are said to get a huge tax break every year due to the fact they organize as limited liability partnerships. Instead of their 20% commission or the “the carried interest” being taxed as ordinary income, it is instead classified as a capital gain and is taxed at lower a generally lower rate (15% if it is a long-term gain but as ordinary income if short-term generally). Others making the same pay would be required to pay a tax rate of 35%, a difference of 20%, and in many cases millions of dollars each year.
Many are angered by the fact that these individuals do not have to pay taxes like other working individuals. When the rest of the workforce earns a commission or a bonus it is taxed just like any other earned income. Hedge fund managers and private equity (much longer to realize profits though) get away with this income being looked at as an investment instead of it being considered a paycheck.
On the contrary, if you reread the definition above from Wikipedia, a key component many need to consider relates to the fact that the hedge fund managers obtain profit in “excess of the amount that manager contributes to the partnership.” Remember, hedge fund managers generally contribute and risk their own capital to the partnership, so profits in essence many argue should be taxed as capital gains income. Furthermore, if the hedge fund manager loses money, generally that has to be made up before any type of carried interest is made. Some of the top hedge funds in 2008, lost 20% or more.
Just How Much Money Would be Gained in Tax Revenue Each Year?
Many might be shocked to find out that if hedge fund managers were taxed at the 35% rate that billions of dollars each year could be generated in government taxes. Some experts say that if the loophole was closed and the tax advantage was no longer on the table, the government could see billions of dollars a year more in revenue. Estimated vary, but the numbers are all in the billions.
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