Boston Tax: Ordinary taxpayers they're not

By Steven Syre, 28 May 2010 -- Boston has more than its share of venture capitalists, private equity managers, real estate partnership executives, and hedge fund honchos. A lot of them are seeing red this week.

What's got them so lathered up? Taxes, or, more specifically, the federal tax rate that applies to a lot of their income. They are angry, they are aghast, they are aggrieved.

They're also dead wrong.

Here's what's happening: After three years of debate, many investment managers who work at partnerships may be about to lose the favorable tax treatment on a big chunk of their compensation that's known as "carried interest." It's really a payment for making profits for clients. But unlike bonuses and incentive compensation in the corporate world, most of which are taxed as ordinary income, carried interest is taxed at the lower 15 percent rate levied on long-term capital gains.

Congress this week is on the verge of passing measures that would turn the lion's share of carried interest into ordinary income, taxed at rates as high as 38.5 percent. In their world, that means big money.

Similar proposals have passed in the House and died in the Senate for several years. But there is a real chance that the outcome will be different this time.

That potentially expensive development has generated an aggressive response from managers of investment partnerships and their lobbyists: Changing the carried interest tax treatment will hurt the economy. It will limit future investments. It will lead to fewer start-ups and fewer jobs. It's unfair!

But it's not, and it won't. Favorable long-term capital gains tax rates exist to encourage investors to put their money at risk in the economy over a period of years, not to benefit the managers of those investments. Nothing under discussion in Washington would change capital gains taxes for investors.

Most investment partnerships charge two kinds of fees: a relatively low flat charge — often 1 percent a year — and a fee of 20 percent or more of any profits they make for investors. This is the so-called carried interest. Managers who don't produce a profit don't get carried interest income, but they don't actually lose money, either.

That's looks like a base salary with a performance bonus. It's not anything like a capital gain.

These fund managers and their supporters argue that higher taxes on carried interest will do harm by limiting money put to work in the economy. Increase taxes on something useful and you'll get less of it, they insist.

That would surely be true if tax laws affecting invested capital were on the table. But investment managers will either eat a higher income tax on themselves or try to increase their fees. A few may be able to charge investors more to cover the taxes, but it's hard to imagine any real economic damage.

Of course, there is another possibility. The investment partnership world is filled with very smart people who know how to get around obstacles. They may find a way around any new tax law before the ink dries on any legislation.

I'd bet all my money on that possibility. But then I'd be stuck paying ordinary tax rates on all my winnings, and who wants to do that?