Fund managers warn against tax change

Top fund managers on Tuesday urged lawmakers to shelve controversial legislation that would change how private-equity and hedge fund managers are taxed on their share of profits, warning that such action could harm other investors.Critics of the current tax code say general managers of hedge and private-equity funds are exploiting a loophole in the tax code that allows them to pay the 15% capital gains tax rate on much of their income - rather than the top 35% ordinary income tax rate - even though much of their take-home pay is derived from providing services rather than from out-of-pocket investments.

The fund managers got little sympathy from tax scholars, who argued that the current tax system inexplicably singles out fund managers for favorable treatment to the disadvantage of other workers and investment firms.
"Why should a surgeon, a schoolteacher or a CEO pay tax at more than twice the rate of a fund manager?" asked Joseph Bankman, a tax law professor at Stanford University.
In most cases, a fund manager or general partner receives a management fee equal to 2% of a fund's assets, plus 20% of a fund's profits, known as "carried interest."
The management fee is taxed as ordinary income. Under current law, carried interest is taxed as investment income. If the fund's profits are in the form of a capital gain, then the fund manager's take is taxed at the capital-gains rate, or 15%.
A bill introduced in the House by Rep. Sandy Levin, D-Mich., would instead tax carried interest at personal income-tax rates as high as 35%. The legislation is designed to tax any income received from a partnership as compensation for services as ordinary income.
Backers of the bill say such income shouldn't be treated as capital gains by the managers since they don't have skin in the game themselves. Instead, they argue that the income is derived largely from managing financial investments, much like a mutual-fund manager, whose salary is taxed as regular income.
Defenders of the current tax treatment argue that fund managers bring capital to the partnership in the form of their ideas, while investors bring capital in the form of cash.
No consensus in Congress yet
Senate Finance Committee Chairman Max Baucus, D-Mont., and Iowa Sen. Charles Grassley, the senior Republican on the panel, say that they haven't made up their minds on whether carried interest derived from investment-management activities should be taxed as regular income.
But they have introduced legislation that would require private-equity firms and hedge funds that opt to go public should be subject to the same 35% corporate-tax rate as other publicly traded investment-management firms.
"There is little difference between a large private equity firm and a Wall Street investment bank," Baucus said. "Both offer merger and acquisition services. Both provide mezzanine financing for transactions. Both offer a wide array of investment strategies for their clients. But only one claims that the income from an active business is passive and is subject to capital gain treatment."
Adam Ifshin, president of DLC Management, a real-estate firm that owns shopping centers and other properties, told the panel that the elimination of the differential between ordinary and capital-gains tax rates for partnerships would undermine the incentive for reinvesting profits. Such a move could hurt poor neighborhoods that have benefited from development efforts, he said.
And efforts to change the tax code have run up against resistance from both parties, including Senate Finance Committee Democrats John Kerry of Massachusetts and Charles Schumer of New York