Jeb! and "Carried Interest": Tax reform or Tax Increase?

 

Presidential Candidate Jeb! Bush has rattled the taxation of “carried interest “ sabre in his newly release campaign tax reform proposal. As I have said, there are some very good things in his ideas and some not so good one. (Such as expanding the abused earned income tax credit and eliminating so many taxpayers from the income tax so about 50 percent of the public has no skin in the game)

Goodness, what can that be? “Carried” what? Who is “Carrying” whom? Carried interests are a business and financial arrangement that are an essential element of business in almost every section of the U.S. economy (including, real estate, private equity, hedge funds, health care, and oil and gas).

In brief, the tax treatment of carried interests allows managers of hedge funds, private-equity funds, venture-capital funds and others to pay a lower income tax rate applied to investment income as capital gains, rather than higher income tax rates.

Many policymakers believe the carried interest paid to partnership managers is really compensation for their management services, which should be taxed at the higher ordinary income rate. On the other side, supporters of the current tax treatment say the carried interest is only a potential share of partnership profits and should not be considered compensation for services.

It is hard to have crocodile tears for the hedge fund and equity fund managers and the like. They have made and continue to make enormous money partially fueled by favorable tax treatment.  Enormous is maybe even too small a word. Even the word undeserving comes to mind. I can say the same thing about entertainers, professional athletes, football coaches and lobbyists who do not share in the same tax breaks. However, that is part of the used-to-be-freer market system we have.

How do they do that? It is complicated but starts with the taxation of partnerships. If you have an interest in a partnership, you are allocated a share of that partnership's income.  The income to the partner takes on the same character, such as capital gains, that it does in the partnership's hands, and the partner is taxed on it accordingly. The partnership itself does not pay taxes. 

Some investment partnerships, particularly in the private equity industry, earn mostly capital gains by buying and selling shares in other companies.  The managers of these companies thus receive their carried interest in the form of capital gains and pay capital gains tax rather than ordinary income tax. Nifty trick!

There are industries other than the financial sector where the carried interest concept is engrained and useful. Changes in tax policy and treatment is worth examining so let us look at the old whipping boy of oil and gas.

In oil and gas development (and in most extraction industries) the term "carried interest" refers to an arrangement where one co-owner of an operating interest (the " carrying party") incurs an obligation to pay all of the cost to develop and operate a mineral property, in exchange for a right to recoup this investment out of the proceeds from the first production. After the investment is repaid, any subsequent production is divided between the other co-owners. The co-owner, not obligated to pay for the development and operation, holds a “carried interest” in the mineral property until the carrying party's initial investment is repaid. There are many different types of carried interests, the details varying considerably from arrangement to arrangement.

A simple example is as follows:

Jack owns all the working interest in an oil and gas lease and wants to drill a well but cannot afford it. Jack assigns to Big Oil the entire interest in the property, and Big Oil agrees to drill and complete a well bearing all the costs. Big Oil will retain 100 percent of the working interest until it recovers its entire costs (drilling, completing, equipping, and operating the well) from the proceeds (or “runs” as they are called) of the production. After cost recovery, a percentage of the working interest in the property goes back to Jack with each party owning a share.

As far as tax treatment, Jack realizes no gain or loss on the transfer of the property even though drilling a productive well only increases the value of the property interest returned to Jack. Jack has a basis equal to his basis prior to transfer. Jack cannot deduct any of the cost incurred.

Jack can receive his share of production income and report it as such, or he can sell his interest as a capital asset. In this simple example, there is no tax partnership arrangement, which can change the tax treatment. However, the point being, this is a long-standing arrangement that serves a legitimate purpose. Big Oil helped Jack finance the drilling of his well which otherwise would not have occurred. Jack intends to take a well-deserved vacation.

The question being, how will this be changed if the carried interested is changed, decimated or otherwise hammered? Will the policymakers make an exception or is any thing fair game. I can understand the reasoning against the equity firms that are also providing management services to earn their carried interest but I do not see the tax abuse for Jack in our example. 

The tax treatment of a carried interest has become a symbol of trying to be for the little guy.  I do not know if Jeb! cares about the little guy or not. I know for liberal Democrats the attack on carried interests is all about social division and raising more money to spend. It is easy to   kick the wealthy because they make sure a great target. Of course, changing the rules to push more income into ordinary income and to erode the treatment of capital gains can lead to other matters, so be careful how hard you kick.