Kevin Williamson At It Again

Kevin Williamson is at it again.  Although undeniably a bright guy, his Stage 4 Trump Derangement Syndrome is causing him to produce sloppy, inaccurate stuff.   The article is especially insufferable because in it Williamson claims that Donald Trump is too dumb to understand carried-interest taxation.  Williamson then proceeds to show he himself has no idea what carried-interest taxation is.

Kevin starts off by purporting to explain the carried-interest “loophole” (which we both agree is not a loophole at all).  He writes: “Here’s how it works.”  But he then proceeds to describe capital-gains taxation, a subject related to, but entirely different from, carried-interest taxation.  He then says that carried-interest taxation is very important to venture capital (VC) and private equity (PE) funds:

If you’re the cash-strapped startup, you go to venture capitalists; if you’re the established business, you go to a private-equity group. In both cases, the deal looks pretty similar: You get cash to do what you need to do, and the investor, rather than lending you money at a high interest rate, takes a piece of your company as recompense (for distressed companies being reorganized by private-equity firms, that’s usually 100 percent of the firm) on the theory that this will be worth more — preferably much more – than the money they put into your business. Eventually, the investor sells its stake in the company and pays the capital-gains tax on its capital gain.

All of this is true, and all of it has nothing whatsoever to do with carried-interest taxation.  Again, he is describing garden-variety capital-gains taxation.  If you or I contribute money to a company in exchange for its stock, then we too will be eligible for long-term capital-gains rates when we sell the stock after owning it for more than one year.  Carried interest has nothing to do with it.

He then goes off on two tangents which actually undermine his support for taxation of carried-interest distributions as long-term capital gains.  First, he claims that PE and VC funds will often provide advice to portfolio companies (i.e., companies in which the PE or VC fund has made an investment).  This is true.  And it is also true that when the portfolio company pays the VC or PE fund money for this advice, either as consulting fees or as compensation for acting as members of its board of directors, that compensation is taxed as ordinary income.

Second, he compares carried-interest taxation to the company stock given to employees as “sweat equity.”  Umm, no.  Company stock given to employees is in fact taxed as ordinary income.  Really, you can look it up!  It’s called section 83 of the Internal Revenue Code.  Only after employees have paid income tax on the fair market value of stock at the time they receive it will future appreciation of the stock will be eligible for long-term capital-gains taxation.  This is why many companies use stock options instead of stock, because stock options typically have no value at grant.

Since Kevin never gets around to describing what he purports to be writing about, I will do it for him.

So what is carried-interest taxation?  Investment fund managers such as PE and VC funds, as well as other fund managers like hedge funds, infrastructure funds, natural resources funds, real estate managers, etc., raise money from institutional investors such as pension funds, insurance companies and high-net-worth individuals.  These investors sign a subscription agreement with the fund manager.  In this agreement they promise to pay the fund manager an annual management fee, usually expressed as a percentage of committed capital (e.g., 2%), for managing the investment.  This fee is taxed as ordinary income to the fund manager.

The investor also agrees to pay the fund manager a specified percentage of fund profits in excess of an agreed upon hurdle rate.  For example, a typical waterfall provision (i.e., the provision in a partnership agreement that dictates the priority of partnership distributions) might say that all distributions go to the investors until they have received back their capital contributions, and then to the investors until they have received the hurdle rate on their capital contributions (e.g., a 10% annualized return), and then distributions in excess of the hurdle rate will be split 80% to the investor, and 20% to the fund manager.  The 20% paid to the fund manager is its carried interest; that is, it is a partnership interest carried by the other investors.

It is important to note that the fund manager typically invests very little of its own money in the fund.  A one percent commitment is typical, but the IRS has ruled that 25 basis points (.25%) is sufficient to be respected as a partner for tax purposes.  In fact, I have seen fund managers put zero capital into a fund and still claim tax treatment as a partner for carried-interest purposes.

People who support carried-interest taxation say that amounts distributed as carried interest should retain their character in the hands of the fund manager; that is, if the investor would have paid long-term capital gains rates on the distribution then the fund manager should get the same treatment.  Other people believe that the diversion of profits from the investor to the manager looks a lot like additional compensation paid to the manager by its client, and thus should be taxed as ordinary income.  I have been a tax lawyer for about 20 years, and among my colleagues there is wide disagreement about which view should prevail.

The bottom line is that I agree that low capital-gains rates are good, that sweat equity is good, that PE or VC advice can be good.  But none of them have anything to do with carried-interest taxation.  I don’t blame Kevin for being confused.  Subchapter K of the Internal Revenue Code (the part that covers partnership taxation) is very complex, and not everyone can be an expert.  But when you’re not an expert, it’s unwise to assail others (even people like Donald Trump) for failing to understand an area you clearly do not understand yourself.

About Conrad

Conrad O'Connor is the nom de web of a tax lawyer working in Atlanta, Georgia.
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