Tiers on my Pillar

When most people think of tiers and taxation, they think of “marginal rates,” effectively the impact of the last dollar you earn on your total taxes. Basically, the more you make, the higher the taxes and the higher the rate you pay (35% is the highest federal rate individuals pay). That’s fair and has been around since the federal income tax structure was put into place near the beginning of the twentieth century. A lot of states parallel the federal structure and tax their residents based on basically the same formulae. And so it is for most people who earn wages, salaries and commissions for a living.

For people who live off of invested income – under the theory that investments take time to grow and mature (with a little inflation eroding the real value over time) – the tax rates drop to 15% at the federal level on any appreciated value that takes more than a year to generate (capital gains). Wealthier people tend to make the bulk of their income on invested assets vs. earned income, but a lot of homeowners have benefited from this rule as well (way, way back when houses appreciated).

But a number of people who make their livings on seeming-commission structures by managing investment funds have been blessed by a special rule – the so-called “carried interest” structure – where if your pay is based on your clients’ appreciation (over more than a year), even if you didn’t invest a dime, you pay taxes on earnings from this invested income share at the vastly lower capital gains rate. This is the world of hedge funds and private equity, where just by getting one of these “better jobs,” you also get these better rates. The argument is that this shared upside carries the same risk of going up or down as does the underlying investment and should therefore be taxed at the same rate. One minor problem with that analysis: the manager has no cash at risk! The client does. 35% vs 15%? BIG difference.

This is unique to this segment of labor. In fact, the law often trips over itself to find ways to tax people at ordinary income rates, even when others get capital gains. For example, if you own a house and sell it after a number of years, you get capital gains treatment. But if you regularly buy and sell houses this way, you are “in the business” of selling houses, and you get taxed at ordinary income rates. You also have the risk of the value of houses going up or down, but people in this trade don’t have the political clout to get their own tax rates.

Not so for the Wall Streeters, well connected and funding campaign contributions to friendly Congress people; they have their own little exemptions for their investment funds. Citizens United pretty much assures these big bad boyz that they will continue to have their way with the rest of us taxpayers by spreading the myth that this is good for America by generating capital investments in the first place. These managers claim they wouldn’t raise and invest all this money without those rates. Yeah, right, what would they do instead to stay rich? Sleep?

Some portions of these investment management fees do get charged as ordinary income rates, but there is a solution for this area as well. “Management fee waivers” are a corollary to the basic carried interest formula. If a manager has enough ordinary income for the year and wants to kick extra income into future years (and convert it to capital gains), there has been an accepted practice (no secret to the IRS) where managers elect to waive the fee they are entitled to and ride the risk by effectively investing that waived fee into the same investment fund. The same argument of risk of loss applies (but by the time the fee accrues to be waived, the investment manager already knows how the fund is doing!), and these folks defer taxes and eventually believe their values are entirely taxable at capital gains rates.

Since state tax laws often track federal laws, when a fund manager flips to a lower rate, the state also loses money. If the feds are too sensitive to the risk of losing campaign contributions from this very-politically active segment of our economy, at least one state official seems to be unconcerned: “The New York attorney general [Democrat, Eric T. Schneiderman] is investigating whether some of the nation’s biggest private equity firms have abused a tax strategy in order to slice hundreds of millions of dollars from their tax bills, according to executives with direct knowledge of the inquiry.

“The [NY] attorney general… has in recent weeks subpoenaed more than a dozen firms seeking documents that would reveal whether they converted certain management fees collected from their investors into fund investments, which are taxed at a far lower rate than ordinary income… Executives at three of the firms subpoenaed by Mr. Schneiderman, who asked for anonymity because they were bound by confidentiality agreements, said that disclosures to their investors clearly stated that the waived fees were allocated equally to all the investments in a fund…

“In 2007, the [federal Internal Revenue Service] began taking a closer look at suspected tax abuses at hedge funds and private equity firms. In a statement at the time, an I.R.S. spokesman said that management fee conversions were among several ‘areas of possible noncompliance.’ But no formal ruling appears to have emerged… Some private equity firms take what tax experts consider a less aggressive approach to the conversions, waiving fees on all of a given fund’s investments over the lifetime of the fund, which can be 10 years.

“But other firms choose which funds or even which particular investments to waive fees on frequently, like every year or every quarter. Such arrangements may allow the executives to apply the waiver only when they believe their funds are more likely to appreciate in value, substantially reducing their investment risk… Mr. Schneiderman is also looking at whether private equity executives treated management fees as a return of invested capital — potentially escaping taxation entirely — or deferred payouts of the converted fees in ways that improperly reduced their tax liabilities.” New York Times, September 1^st. Makes you want to root for the little guy, the hard-working individual taxpayer who seems to be shouldering a disproportionate burden. But we clearly have two tracks of rules, regulations and tax rates: one for the wealthy… and the less-beneficial ones for the rest of us. Think that will change anytime soon?

I’m Peter Dekom, and if you want to see how political systems eventually collapse, look back in history at those societies that created the same favoritism among economic elites… and see what happened to them.