Renaissance did not avoid $6b in taxes. They never owned the stock in the baskets that the politicians claimed they did. The payout to risk ratio of the options is most likely why they were invested. There can't be a social function to not paying because there was nothing to pay.
I don't know specifically about Renaissance's case, but they may well have avoided $6B in taxes if a lot of their fees were categorized as "carried interest". (I don't think the particular fact that they invest in derivatives has anything to do with it.) For hedge funds any fees they accrue for "performance" are carried interest and not subject to regular income tax, though they will eventually be taxed at the capital gains rate. E.g., if a hedge fund charges 2% of assets annually, plus 20% of annual increases in asset value over 8%, the 2% fee would be taxed as regular income and the performance part (20% of increases > 8%) would accrue to them as carried interest, treated as capital gains.
My not-so-informed belief is that while there may originally have been a decent rationale for treating hedge fund performance fees as carried interest, in many (most?) modern hedge fund scenarios that categorization is misapplied. In any case, the treatment as carried interest is legal, at least for now.
Those taxes are not avoided - it's just the current tax law. Money put at risk is taxed as capital gains. You don't automatically get carried interest - if you don't perform, it's zero.
Think of it as a portion of their salary that they are contractually bound to invest in the fund, with deference to the limited partners.
Do we really want to have fund managers without skin in their own funds? Carried interest is the only way to do that that does not favor the fantastically rich - who have enough advantages already. Ask yourself what might happen to the private fund industry (VC, PE, hedge funds, real estate, etc) if managers were not able to get carry. How would their compensation change? Which funds would benefit? Do we really want that?
It's not an issue of whether someone should get carried interest - it's an issue of the rate at which that carried interest is taxed.
Funds are essentially providing a service for a given investor but getting taxed as though it was all their own money in the fund - which is not the case in most funds.
Instead, what the funds are doing is essentially providing investment advice - for which the fees should be taxed at normal rates rather than at the carried rate as though it is all their own money.
So I have no issue with the manager getting carried interest or being taxed at lower rates on their own money - but when they take money from outside investors, they should be taxed at normal rates.
I won't argue that our tax code is anything but ridiculous. But treating carried interest and capital gains the same way makes sense - it's money put at risk as an investment. I don't think it's relevant that in one case cash is risked and in another case it's compensation at risk. Nobody is goign to argue that the management fee is capital gains because it isn't - it's guaranteed cash. It's different.
I think you can argue that capital gains shouldn't be taxed differently than income at all (not sure what I think of that, honestly), but if carried interest has to be in either the "income" bucket or the "gains" bucket, it looks more like gains to me.
"I think you can argue that capital gains shouldn't be taxed differently than income at all (not sure what I think of that, honestly), but if carried interest has to be in either the "income" bucket or the "gains" bucket, it looks more like gains to me."
Looks more like income to me - fees paid to people for managing money that they themselves have not put at risk.
Again, we're not talking about getting carried interest - we're talking about the taxes on that carried interest. They put the capital at risk, but this is no different than any fee-based service, thus it is income rather long term capital gains.
If they took part of their salary and opted (or were required by LP's) to invest that money in their fund, should any gains there be taxed as capital gains or ordinary income? They would clearly be capital gains.
What is the difference between that and carried interest? The only thing I can think of is that it's not taxed as ordinary income before being invested, which is a fair criticism. On the other hand, you don't get a tax benefit if you lose that money in the CI case (which happens a lot), so it balances out at least to a degree.
"Because the fees charged by the mutual fund guys are fixed - it's a straight percentage of assets. Just like the fees charged by hedge funds which are taxed as ordinary income."
Taxable methodology isn't generally determined by the way you earn your income. The concept of long term capital gains was created to reward investors (those who invest their own capital) who hold capital in a given investment vehicle for over a year, not for whether or not they are taking on risk, or whether they are paid out based on a fixed fee or fixed percentage of profit. We don't tax waiters at a different rate for the money they get on tips (sweat equity) vs. their base salary.
Fees charged by private equity are also fixed - they are a fixed percentage of profit. So again, I don't see why this is any different. We have an investment vehicle taking in money, making investment decisions on the behalf of their investors and then making a percentage of the profits - all normal activities - nothing that warrants special tax treatment.
> Taxable methodology isn't generally determined by the way you earn your income. The concept of long term capital gains was created to reward investors (those who invest their own capital) who hold capital in a given investment vehicle for over a year, not for whether or not they are taking on risk, or whether they are paid out based on a fixed fee or fixed percentage of profit.
There's a pretty good argument that some special treatment of income from long-term holdings (or, at least, something that accounts for them) is necessary in a system with progressive taxes on annual income, because otherwise small investors with infrequent realizations of income from long-term holdings would be taxed more on their income (on average) than people with the same average annual income who made constant income year-to-year.
OTOH, one can argue that the particular mechanism of long-term capital gains is a bad mechanism for that because it doesn't account for similarly irregular non-capital income (e.g., a writer whose income is mainly royalties that are concentrated immediately after new book releases who infrequently releases books that are bestsellers, but with several years of minimal income in between) and, at the same time, undertaxes capitalists that can afford enough in long-term holdings that rotate to realize constantly high income from long-term holdings.
Things like hedge funds and carried interest are sort of nibbling around the edges.
I'd have no issue with their own investments in the fund being taxed as long term capital provided they have held the investment for a year when the profit is taken.
Here's a simple way to think about it - an ordinary RIA invests money on behalf of their clients. The fees they get for that service are taxed as ordinary income. Why should carried interest be any different when the money is coming from clients? And why should carried interest be taxed at a lower rate regardless of hold time? The simple answer is that these fees aren't any different - and therefore should be taxed at the same rate in my opinion.
Because the fees charged by the mutual fund guys are fixed - it's a straight percentage of assets. Just like the fees charged by hedge funds which are taxed as ordinary income.
To take it a step further, should entrepreneurs pay ordinary income tax on their gains when they sell their company if they didn't invest any of their own money? It's the same thing. Carried interest is just a fancy name for sweat equity.
"Because the fees charged by the mutual fund guys are fixed - it's a straight percentage of assets. Just like the fees charged by hedge funds which are taxed as ordinary income."
Taxable methodology isn't generally determined by the way you earn your income. The concept of long term capital gains was created to reward investors (those who invest their own capital) who hold capital in a given investment vehicle for over a year, not for whether or not they are taking on risk, or whether they are paid out based on a fixed fee or fixed percentage of profit. We don't tax waiters at a different rate for the money they get on tips (sweat equity) vs. their base salary.
Fees charged by private equity are also fixed - they are a fixed percentage of profit. So again, I don't see why this is any different. We have an investment vehicle taking in money, making investment decisions on the behalf of their investors and then making a percentage of the profits - all normal activities - nothing that warrants special tax treatment.
Comparing selling your company to carried interest isn't appropriate - apples and oranges - but to your entrepreneurs example: if they accept investment in their company, then their company has shares. Gains on those shares are treated exactly the same as any other share in any company - short term gains on stock held less than a year or long term if you've held it a year or longer. This is why many people exercise their options in a startup as a way to start that clock as soon as possible to avoid short-term tax consequences.
Again - PE firms are offering a service and will receive a good profit for their hard work. But that work often involves minimal capital on their part and therefore should not be treated as if it is their capital at risk.
"Money put at risk is taxed as capital gains." Huh? Money that hedge fund owners provide as fund capital is already theirs, they don't pay tax on it at all. Of course gains in value of their capital investment are taxed as capital gains. But the performance fees we're talking about are fees that accrue to hedge fund managers from managing _other people's money_, not the capital gains that manager's realize directly as the increase in value of their own investment.
If hedge fund managers could not performance fees categorized as carried interest they'd pay regular income tax rates on them. Not sure how that changes their management of the funds. Presumably if they believe they're the best managers out there they'll want to have their own assets in their fund (and of course will pay only capital gains tax on increases in value of their assets). By the way, high percentage of hedge fund managers are already among the "fantastically rich". . . .
