When I was studying taxes in business school, I occasionally came across a law that just didn’t make sense to me.
Sometimes, my professor could explain its intent and rationale. Other times, he just smiled and said, “Someone paid good money for that one.”
There are two ways to make money. You can invest your time, in the form of labor, or you can invest your money, in the form of capital. If you invest time, you pay income tax at ordinary rates, and if you invest money, you can pay at the lower rate for capital gains.
Unless you are an executive at a private equity or a venture capital firm, that is.
These firms generally use what is known as a two-and-twenty pay structure. Managers are paid 2 percent of fund assets as an annual management fee and 20 percent of the profit earned for investors above certain levels.
For years, these executives have insisted that, while the 2 percent is employment income, the 20 percent is investment income. Long-term capital gains are taxed at 15 percent, while ordinary income rates can be as high as 35 percent, so it makes sense that fund managers want their pay to be considered a capital gain.
But their reasoning makes no sense. They make a lot of money with the two-and-twenty pay schedule. They say that that is because they’re worth a lot of money; they put in long hours and they work hard. But, that’s just it: they put in time, not money.
The lower rate for capital gains is intended to encourage people to invest in businesses so that they can grow, strengthening our economy. Fund managers are compensated for their talent and effort, not for their investment. They should not qualify for the incentive.
Private-equity and venture-capital firm managers are paid to provide a service to investors, just as the investment advisory affiliate of Palisades Hudson is paid to provide a service to investors. Since our clients are the ones who put in the money, they are the ones who have capital gains. The money that they pay us to help them achieve those gains is just regular income.
The proposal now under consideration in the House would require managers at private equity and venture capital firms to start treating their ordinary income as ordinary income.
Fund managers say that the change would be “exactly the wrong policy at the wrong time,” as Douglas Lowenstein, president of the Private Equity Council, a Washington trade group, put it.
During the past two decades the tax code has been salted with provisions that target upper-income taxpayers not just with higher rates, but with a completely separate set of rules. These taxpayers face fiscal discrimination on everything from itemized deductions to first-time home purchases. While Congress has every right to impose heavier tax burdens on those it deems better able to bear them, such back-door tax hikes makes the system far more complex, cumbersome and expensive for government and taxpayers alike.
But simplicity and fairness go both ways. Unjustified tax breaks heaped on small groups of well-connected taxpayers, such as fund managers, provide much of the political rationale for the unfair hidden taxes that target high-income citizens generally.
The bigger issue here is not whether private equity and venture capital managers should pay more or less in taxes, but whether our tax code should consist of laws that make sense or laws that somebody paid for.