Yes, there is something terribly wrong with taxation in the hedge fund industry — but it is not the perceived evil that the defeated Baucus/Grassley bill was attempting to “fix”. According to them, the problem was that the hedge fund operators get part of their compensation from (relatively low-tax) capital gains income.
However, the proposed changes to “carried interest loopholes” is for political gain only, creating a problem that isn’t there, in order to solve some mythical inequality. However, all it does shift the benefit of the capital gains lost by the operators to the investors. That fixes nothing.
Instead, the real problem is that the Internal Revenue Code (IRC), as strictly enforced by the IRS, requires generally that hedge fund investors pay taxes on huge amounts of “income” that does not exist. This is derived from rules that require investors to pay tax on investment income while denying them an offset for the expenses that were incurred to generate that income.
It is simply not uncommon for hedge fund investors to pay tax rates of 70-100% or more on the hedge fund income they earn.
Yes, you read that correctly. 100% or more. In fact, in my practice I see a few clients every year forced to pay more taxes on an investment than that investment earned. True, it is a small percentage of people affected in any given year, but this does not mitigate the blatant unfairness. How does this injustice take place?
It follows from what is the most inequitable provision of the current tax code, namely, the severe limitation on the ability to deduct the necessary expenses incurred by a hedge fund operator in order to earn income: investment fees and expenses, accountant’s fees, legal fees for collecting a settlement, etc.
The tax code requires those expenses — which include virtually all operation expenses of private equity hedge funds, including fees to the operators — to be listed under the category of “miscellaneous deductions”.
However, these deductions may not be claimed until and unless they reach 2% of the taxpayer’s entire income. The upshot of this is that most taxpayers do not get to benefit from these deductions. To add further insult to injury, that even if investors have expenses which exceed the threshold, these expenses become addbacks for the dreaded alternative minimum tax (“AMT”).
This taxpayer abuse then certainly discourages investment and is a major source of inequity in the code. If Congress were ultimately concerned with reforming the hedge fund industry, this problem — the inability to deduct necessary expenses incurred while earning income — would be the right one for Congress to fix. Trying to interfere with and fix who gets the capital gain rate in a “carried interest” transaction was a worthless and meaningless endeavor.