Raising Taxes on Hedge Fund Managers

Ever wonder how hedge fund managers can become centi-millionaires or even billionaires in relatively short time spans? It isn't uncommon for a hedgie to build such a substantial net worth in less than a decade. Besides the extremely generous fee structure they command (I blame the customers for actually paying it), there is another factor that contributes to their wealth accumulation: a tax break. (In case you forget what a hedge fund is, see our older post on hedge funds.)

You see, hedge funds typically charge what is called "2 and 20". This is short for a 2% annual management fee and a 20% performance fee. That is, they keep 20% of the fund's profits (above the high water mark). Let's say they manage a $500 million. Let's also say they have a good year and the fund climbs 15%. Their fees would amount to (roughly) $25 million comprised of $10 million in management fees (2% of $500 million) plus 20% of the fund's $75 million profit or another $15 million.

Here is where it get's a little complicated, so I'll simplify. That $25 million in earnings would be worth only $15 million after taxes (assuming a typical 40% tax rate of 35% Federal and 5% state- probably a little more than 40% in most states actually, especially CA and NY where it may top 50%). But hedgies don't pay income tax on all that. You see, the performance fee is "carried interest", not income. Carried interest is a considered a return on investment and not compensation for services rendered. As you may know, returns on investment are taxed differently than compensation. Long-term capital gains (gains on investments held more than one year) are taxed at just 15%. Likewise, dividends are also taxed at just 15%. So a large portion of a hedgie's income might be taxed at only 15% despite earning tens of millions.

To be fair, it is a bit more complicated than just described and probably not all of the performance fee is taxed at 15% (it depends on the mix of income to the fund). Yet for many hedge funds (especially private equity and venture capital), this is a giant gift. Consider that the hedgie did not risk any of their own capital. How could it be a return on investment if there was no investment? And isn't the fee for performance? Wasn't your bonus for performance taxed as income? Aren't tips pay for performance too? The logic of this generous tax regime is highly dubious, yet persists.

The WSJ reports that the House is likely to vote to change this tax treatment. Perhaps surprisingly, it faces opposition from both parties. In fact, the Senate Finance Committee Chairman, Montana Democrat Max Baucus said it will face "tough sledding". Why? Well, my only guess is the giant campaign contributions hedgies make to politicians of all stripes. Donations which are paid for by the very taxes they aren't paying.