Carried Interest: Secret Billionaire Tax Break May Disappear

The Senate yesterday set in motion the vote that will determine whether Congress has learned anything, anything at all, from the financial train wreck of the past two years.

This litmus test isn’t the financial reform package, a weak brew that’s now proceeding forward in slow motion, health care-style. Instead, a little-noticed measure in a bill to extend unemployment benefits presents the purest question of national priority we’ve had in a while: Is the act of pushing money around still considered more socially valuable than actually creating things? And its corollary: Do Wall Street millionaires and billionaires, the folks responsible for a large chunk of the mess we’re in, still deserve to pay less than half the tax rate of the rest of us?

“Defending it is nothing but a set of excuses and created explanations to try to protect our own interests,” the big-shot private equity player tells me.

For decades, this subsidy for Wall Street tycoons, known as “carried interest,” has allowed virtually all private equity honchos (guys who carve up entire companies), venture capitalists (guys who provide seed investment in companies), and real estate partners (Donald Trump), as well as many hedge fund managers, to get their annual bounty taxed at 15 percent versus the 35 percent incurred by most readers of this article. If the investors in these funds got their profits taxed as capital gains, the argument went, then those “creating” this extra value, who make the bulk of their income taking a chunk of said profits, should pay that lower rate, too.

Yet corporate executives who create value get taxed in full on their comp packages. Engineers who create value with a patent get taxed in full on their big bonus. Innovative teachers get taxed in full on their merit raise. Compensation is compensation, but only Wall Street’s alternative asset fund managers get the tax break, expected to approach $20 billion over the next decade.

This fat cat windfall has been targeted for years. Two weeks ago, the House eked out a repeal of the exemption, and yesterday Senate Democrats sent their own version to the floor. But since this is dysfunctional Washington, Democrats in the Senate and House face a showdown. As with health care, the Senate tempered its version of the bill, and it remains unclear where the 60th Senate vote will come from. (Olympia Snowe, the most likely convert, remains uncommitted.)

Such halting progress at the southern end of the Acela corridor has caused no shortage of private chortling among those who earn millions or tens of millions or hundreds of millions a year. Carried interest is that rarest of tax breaks: Even those benefiting don’t buy into it.

I talked to half a dozen top private equity players and other money managers, Republicans and Democrats in equal number, and not one, even with the necessary cloak of anonymity, chose to defend why they are paying less than half the tax rate you do.

“Virtually everybody in the private equity community knows that they have been receiving a gift for as long as people can remember,” says one of America’s best private equity fund managers, with billions in deals under his belt.

“It makes zero sense,” adds a second private equity partner, who has bought and sold several famous companies. Carried interest “is purely compensation. How is it possible that a teacher is taxed at ordinary income and I’m not?”

A third, who runs a small firm after a stint as one of the five most important people at one of the five most important banks, puts it in the succinct way of someone who makes his money dicing the world into crisp, logical patterns: “It is indefensible.”

How indefensible? Before the House vote, the money lobby dispatched to the Capitol the walking embodiment of the tax break’s absurdity, Blackstone billionaire Steve Schwarzman, who in February 2007 defined the last decade by throwing himself a $3 million 60th birthday party, complete with serenades from Patti LaBelle and Rod Stewart, and replica paintings designed to transform the giant Park Avenue Armory into a mirror of his $37 million Manhattan apartment. That’s not really the guy who should be groveling for his personal tax break.

Perhaps most distasteful is that Schwarzman likely knows, in his heart, that the carried interest exemption makes no economic sense. “Defending it is nothing but a set of excuses and created explanations to try to protect our own interests,” the big-shot private equity player tells me. The consensus figure among the six asset managers I talked with is that 80 percent of their peers will privately admit as much. And the other 20 percent? “They’re wedded to it,” says another private equity partner. “They’ll say, ‘It’s my allocation. It’s the law. We’re entitled to it.’”

That’s the key word: entitlement. More than the entrepreneurs who do the hiring, the engineers and scientists who create the breakthroughs, the teachers and professors who train the entrepreneurs and scientists, the industry’s high-paid lobbyists—private equity has poured in almost $50 million over the past three years—have to argue alternative asset managers are the most important, noble people in the economy, as deemed by the U.S. tax code.

Without the carried interest rate, lobbyists will tell you with a straight face, the engine of capitalism would break down. “Now is not the time to upend more than 50 years of partnership tax law,” says Private Equity Council president Douglas Lowenstein. Companies wouldn’t be funded. Liquidity would dry up. Jobs would disappear. And their minions on Capitol Hill repeat the party line. “This is not a time to raise taxes on investments in business,” echoes Nebraska Rep. Lee Terry.

Unlike politics, though, Wall Street craves dispassionate numbers. So let me do a math exercise, as someone who co-founded and ran the largest magazine for dealmakers in the world and twice had the privilege of nine figures of private equity backing for unsuccessful buyouts.

First, ending the carried interest exemption wouldn’t change how much dough gets poured into these funds. The endowments, pension funds, rich families, and the like don’t much know or care what those managing their money pay in personal taxes. It doesn’t affect them one iota.

Second, it wouldn’t affect how much gets invested back out. Again, generating returns for the firm has nothing to do with the personal tax rate of the partners.

The only thing to be affected, if you believe the histrionics of supporters, is that fewer first-rate people will become fund managers. And that’s a good thing.

Even 20 years ago, you could have made a strong case that a tax break for money managers made American business more efficient, seeded our great startups, and gave mature companies funding options. But the last decade decimated that idea. Too much money, backed by too much leverage, fueled an insane asset bubble—and collapse.

So if a few extra math geniuses now choose to build things rather than cut them up, that would be a societal good onto itself.

Randall Lane is the former editor-in-chief of Trader Monthly, Dealmaker and P.O.V. Magazines, and the former Washington bureau chief of Forbes. His book, The Zeroes: My Misadventures in the Decade Wall Street Went Insane, will be published in June.