“Think Twice Before Raiding Carried Interest” says the title
of Pam Hendrickson's article in the Wall Street Journal edition of April 9,
2013. Yes, indeed, I would say, think twice before raiding carried interest
then raid it with a vengeance. The Hendrickson article also has the subtitle:
“A basic tenet of law since 1913 is that when a partnership receives a capital
gain, so do all the individual partners.” And this anachronism is one of the
reasons – but not the only one – as to why the current system needs to be
revamped or replaced.
The author begins by admitting that “a simpler, fairer tax code will … provide businesses with the
clarity and certainty they need to invest, build and innovate for the future ...
That's progress.” But then, she quickly cautions that “the politics of comprehensive
tax reform are tricky. Carried interest is a case in point.” What she seems
oblivious to is that politics is the dragon that needs to be slain so as to
“provide businesses with the clarity and certainty they need.” This is the
reality that Washington
is facing at this time, and the choice that needs to be made cannot be any
clearer.
The beneficiaries of carried interest are basically the
private-equity funds whose interests she defends by affirming that “the current tax
treatment of carried interest – as a capital gain – is entirely appropriate.”
If you ask: Why is that? She responds: “Private-equity funds ... buy companies
they can improve over time with an injection of capital, a dose of management
expertise and a fresh vision for growth.” Good for them, if that is true. But
then again, plenty of other enterprises who seek no preferential tax treatment
do that kind of work. More than that, they are firms that have not a “jack of
all trades” phony expertise, but professional expertise in a specific field of
endeavor about which they give the kind of advice that makes the equity fund
managers look like con artists right out the amateur league, here to stage a
clownish performance and pocket a hefty sum.
These would be the consulting firms that live and die by
their reputation. When first approached by a potential new client, they do the
best research they can in a field they already know well then give the best
advice for a fee. They get paid a salary, and pay taxes accordingly. In living
by this model, they seek to win the confidence of their clients so as to
maintain a long lasting relationship with them; a relationship that will remain
beneficial to both sides on a continuing basis. Now, contrast this with what
Hendrickson says the private-equity funds do: “If the company succeeds, the fund can sell
it for a profit and make money.” She thus admits that what the equity firms do
is have a one night affair that serves the interest of the fund managers, and
maybe a handful of partners but no one else – not the workers, not society, not
the economy, not the country.
To plead her case for maintaining the current system, Pam
Hendrickson invokes the Internal Revenue Code of 1913 whose basic tenet of
partnership law “is that individuals
are taxed based on the character of the partnership's profits, meaning that if
the partnership receives a capital gain, so does the individual partner.” Based
on this, she makes the case that “Private-equity funds buy and sell companies ... As
a result ... the profits realized ... should flow to the limited and general
partners of the fund and be taxed as capital gains.”
What is wrong with this presentation is that private-equity funds and real-estate
partnerships did not exist in 1913 when the Code was enacted. A hundred years
later, America
finds itself saddled with firms that have organized themselves in such a way as
to create loopholes where none were envisaged and none would have been
tolerated by the legislature that formulated the old Code.
What happened over
time is that monstrous salaries started to be paid to managers who then claim
it as capital gains thus pay minimum tax. For this reason, it is incumbent upon
the current legislature to remedy the inequities that have resulted – and do so
by revamping the Code of 1913 or replacing it altogether with something that
suits the times.
At the start of her long closing argument, Hendrickson
laments: “That doesn't sound like the
country I know, and it doesn't reflect the spirit of entrepreneurship,
ingenuity and hard work that has propelled the U.S. economy for two centuries.” Oh
yes; she is not alone harboring this sentiment because the people who
formulated the Code of 1913 – they too would not recognize the country that America has
become.
To them,
entrepreneurship meant to create something where none existed. It did not mean
to feed on something that has fallen on hard times. This is why “clarity and
certainty” need to be restored to the businesses no matter how tricky the
politics involved.
It takes hard work
and ingenuity to build a monument but takes little effort to raid a lame
enterprise. For this reason, it is time to raid the raiders and return to America the
character that made it great.