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Why is carried interest still a thing? Why are fixed fees taken by investment managers not taxed as income? I think the current administration could fix these

by useful 5y ago

Why is carried interest still a thing? Why are fixed fees taken by investment managers not taxed as income? I think the current administration could fix these things easily but we are talking about all kinds of other things while ignoring low hanging fruit.

danielmarkbruce 5y ago
It's not as easy to fix as it seems at first glance. Imagine I put up $1 million, and you are a chef, and we go into business together. You get 20% of the restaurant company for being the brains of the operation. In 10 years we sell it for $2 million. You get $400k. I get $1.6 million. Should my gain be capital gains? What about yours? Some folks feel that all human labor and human capital should be taxed as income. Others think it would be distasteful if on the successful exit outlined above, the chef had to pay higher tax on his 20% ownership than the capital provider ie said folks think that everyone should pay the same tax rate on the sale of the business. Others think that in my example the chef has brought capital to the table in the form of skills/knowledge learned, ie human capital. So, everyone is getting taxed on capital in the same way. The chef gets his monthly salary taxed as income, which is payment for labor. None of these positions are obviously flawed. It's pick your poison. Creating a tax system isn't easy.
- deleted 5y ago
  [deleted]
- useful 5y ago
  Thats not the same thing. Imagine there is a 3rd person whos whole job will tell you that they "know" when to sell the restaurant. For this, they will charge a 1%/year flat fee based on the current value of the business. They'd average 15k/yearly for 10 years. They also charge carried interest on your paper gains, so 10% performance on your 100k/year average gain, another 10k/year. They are effectively making a salary for labor but only paying 0-20% on 25k/year from our business depending on how many other clients they have. This is much lower than the 10-37% most workers pay on their labor. I'd argue that the business sale is capital gains. I never said it wasn't in my original post. Carried interest and a fixed flat fee to manage an investment (which most people call a salary) should not be taxed as if they are capital gains.
  - danielmarkbruce 5y ago
    There are situations which are quite simple and, I agree with you they seem to be taxed the wrong way. It's just harder to fix than it seems because the spectrum of what people actually do when involved in a business is wide. Most situations are something in between your example of a person who "knows" and mine of a chef. The chef in my example "knows" what kind of food to create for a given area - ie the intersection of demographics/tastes, the existing competition, locations etc. That expertise is equivalent to your "knowing". The chef might not even actually work day to day - he/she just had the initial insights. Now the chef has moved along the continuum towards a finance person. In almost all the modern successful PE operations, the teams are industry specialists (ie if you look under the hood at Blackstone, KKR etc, the people are organized by industry). They actually know a lot about the operations, what can be improved, what needs to be thrown out etc. They are something in between my "chef" and your "person who knows". By and large, they aren't timing markets. Even VCs are becoming industry focused as opposed to generic. Many are former founders. They have stepped down the continuum toward being a "chef". ie, most folks are in the grey area. WRT business sales - at least for PE/VC folks, the carried interest is calculated on the business sale. There are some situations where they can write things up or down, but it washes out - ie they can't just write it up arbitrarily - the value of the asset, and hence their capital - needs to have actually gone up.

by useful 5y ago

danielmarkbruce 5y ago

It's not as easy to fix as it seems at first glance. Imagine I put up $1 million, and you are a chef, and we go into business together. You get 20% of the restaurant company for being the brains of the operation. In 10 years we sell it for $2 million. You get $400k. I get $1.6 million. Should my gain be capital gains? What about yours? Some folks feel that all human labor and human capital should be taxed as income. Others think it would be distasteful if on the successful exit outlined above, the chef had to pay higher tax on his 20% ownership than the capital provider ie said folks think that everyone should pay the same tax rate on the sale of the business. Others think that in my example the chef has brought capital to the table in the form of skills/knowledge learned, ie human capital. So, everyone is getting taxed on capital in the same way. The chef gets his monthly salary taxed as income, which is payment for labor. None of these positions are obviously flawed. It's pick your poison. Creating a tax system isn't easy.

deleted 5y ago
[deleted]
useful 5y ago
Thats not the same thing. Imagine there is a 3rd person whos whole job will tell you that they "know" when to sell the restaurant. For this, they will charge a 1%/year flat fee based on the current value of the business. They'd average 15k/yearly for 10 years. They also charge carried interest on your paper gains, so 10% performance on your 100k/year average gain, another 10k/year. They are effectively making a salary for labor but only paying 0-20% on 25k/year from our business depending on how many other clients they have. This is much lower than the 10-37% most workers pay on their labor. I'd argue that the business sale is capital gains. I never said it wasn't in my original post. Carried interest and a fixed flat fee to manage an investment (which most people call a salary) should not be taxed as if they are capital gains.
- danielmarkbruce 5y ago
  There are situations which are quite simple and, I agree with you they seem to be taxed the wrong way. It's just harder to fix than it seems because the spectrum of what people actually do when involved in a business is wide. Most situations are something in between your example of a person who "knows" and mine of a chef. The chef in my example "knows" what kind of food to create for a given area - ie the intersection of demographics/tastes, the existing competition, locations etc. That expertise is equivalent to your "knowing". The chef might not even actually work day to day - he/she just had the initial insights. Now the chef has moved along the continuum towards a finance person. In almost all the modern successful PE operations, the teams are industry specialists (ie if you look under the hood at Blackstone, KKR etc, the people are organized by industry). They actually know a lot about the operations, what can be improved, what needs to be thrown out etc. They are something in between my "chef" and your "person who knows". By and large, they aren't timing markets. Even VCs are becoming industry focused as opposed to generic. Many are former founders. They have stepped down the continuum toward being a "chef". ie, most folks are in the grey area. WRT business sales - at least for PE/VC folks, the carried interest is calculated on the business sale. There are some situations where they can write things up or down, but it washes out - ie they can't just write it up arbitrarily - the value of the asset, and hence their capital - needs to have actually gone up.