Olympus Partners AUGUST 30TH, 2021 Romancing the Stoned Romancing the stoned. Stoning was once a punishment in ancient Greece. The modern version of stoning is creating a tax solely targeted at a group of people you disdain. Decades ago, the real estate business adopted the concept of carried interest, a concept first created in the sixteenth century to reward the crew of a ship for the transport of goods they carried. This arrangement was employed as a means of dividing the profits on a real estate project between the developer and his investors. Decades later, venture capital managers, then more broadly, private equity managers adopted the same structure. The gains being divided, due to the long-term nature of the investments, were long term capital gains. Today’s efforts to change the taxation of these gains only if they are handed to certain parties, such as private equity managers, have strong advocates in favor and in opposition. Now, however, in this new era of demonization, we have Senator Ron Wyden, a man whose entire career has been funded by taxpayers, who wants to tax or to stone private equity managers even if they do not earn any carried interest. Using classic political logic he creates a false premise that “carried interest is taxed as income from the partnership, which allows the deferral of tax payments until future investment sales” and then offers a solution. This quote from his recent August press release revealing his newly proposed PE tax falsely implies that not paying tax until you sell an asset is a deferral. In fact, in every aspect of the U.S. tax system, you must sell an asset – a stock, a house, land etc. before you owe any tax. Wyden’s plan for taxing this nonexistent income is even more pernicious. He declares carried interest is really “an interest free loan, at a rate he sets at 14%, in a world where no such rate exists, and taxes it annually as “deemed compensation” even if the PE Fund has no income. “For example, if the Fund manager receives a 20 percent carried interest in exchange for managing investors’ capital of $100 Million, and the prescribed interest rate for the tax year is 14 percent, the Fund manager would pay the top ordinary income tax rate of 40.8 percent tax on $2.8 MM of deemed compensation” 1. Wyden 8/5/21 press release. If the Fund did not earn any profit for its ten year life, the General Partners would still owe tax on $28 MM of “deemed income”. If one were to apply this principal to all U.S. taxpayers, as is generally required by tax law, the following would ensue: Friends invest $200,000 with a contractor to build a house. In return, the contractor gets 20% of the profit when the house is sold. It takes three years to build the house. Per Wyden’s logic, the contractor owes $200,000 x .20 = $40,000 x .14 = $5,600 x .405 = $2268 in income tax annually despite not earning a dollar. The slippery slope leads to unrealized gains in your home, your land, and your stocks being taxed annually. Over recent years, several younger investors, trying to start PE firms have come to visit us about starting a firm. If you add this burden, taxing phantom income, how do they begin? If the firm does not earn profit will the government refund their money? If the DA found evidence of a scheme like this resulting in protection money being paid to organized crime you would arrest the promoter. George Will once commented, “Being elected to Congress is regarded as being sent on a looting raid for one’s friends”. Beyond the obvious unfairness of this looting the potential exists to sever the alignment between general and limited partners in the best performing asset class in institutional portfolios. Inevitable schemes to avoid this tax or to pass it along as a partnership expense will result. Short-term goals will become very important in order to satisfy this real, albeit manufactured, liability. As in the normal economic process, the cost of this will be passed along, in some fashion to the consumer. I’m Rob Morris and I approved this blog. < Previous Back to Rob's Blog Next > HOME STRATEGY TEAM PORTFOLIO CASE STUDIES ABOUT NEWS CONTACT US © 2021 Olympus Partners. All Rights Reserved. Terms of Use Site design: The Monogram Group