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Carried interest legislation: Ready, shoot, aim

Will Rogers said, “I don’t make jokes. I just watch the government and report the facts.”

No jokes today, just some government facts.

Good stories have a bad guy. There’s plenty of them. In my youth, it was Snidely Whiplash, the cad who tied his girlfriend, Nell Fenwick, to the railroad tracks. Thanks to Dudley Do-Right, Canadian Mountie, for saving the day.

In modern times it is the hedge fund manager. Also eligible is the private equity fund manager and the venture capital fund manager.

These people receive what is known as a “carried interest.” This implies they are trading an equity interest for future profits. Kind of like the guy at the craps table who leaves his winnings on the pass line.

What’s so bad about that? Well, for one thing, there really is no equity being traded for profits. Instead the manager is getting rewarded for investment services rendered during the life of the fund.

Again, what’s so bad about that? Well the fund manager wants to get tax-favored treatment for these rewards. Instead of ordinary tax rates, capital gain rates apply. That’s about a 50% discount on rates.

There is definitely an inequity here. The problem is how to solve it. The tax result flows from a natural application of long-standing partnership tax rules.

Fixing the problem would require changing these long-established rules. If only we had a strong, honorable Canadian Mountie to do this.

Canadian Mounties are not allowed to write U.S. tax law. I checked this and found it to be true. So we must rely on Congress.

Congress made some minor changes to these carried interest rules in the 2017 Tax Act. The Senate has proposed more radical changes. Senate Bill 1598 changes partnership tax law.

This column is roughly 700 words. The new proposed section — that’s one section — creating carried interests fairness is 6,328 words.

The Congressional Research Service provides summary descriptions of bills. CRS says the proposed law would apply to private equity or hedge fund managers.

The bill actually applies to carried interests received in partnerships that invest in “specified assets.”

It is important to define who or what you are talking about. If parties are not on the same page, one or more of them may be needlessly hurt.

In the great Pink Panther film series, starring Peter Sellers as the bumbling French Inspector Clouseau, many such miscommunications occur.

Inspector Clouseau, disguised as a professor, enters a hotel and asks the clerk for a “reum.” Confusion caused by Clouseau’s accent led to an immediate problem. But it got worse.

Noticing a dog on the floor, Clouseau asks, “Does your dueg bite?” The clerk answered “no.” Clouseau then bends down and, reaching his hand, is promptly bit.

“I thought you said your dueg did not bite!” That is not my dog, the clerk answered. Clearly the right question was not asked.

The right question to ask with carried interests is who we, as a society, want to subject to complex new laws to achieve a more fair tax result.

The Senate bill includes real estate rentals or investments as “specified assets.” So while the CRS explanation notes the application to hedge fund and private equity managers, the legislation is more broad.

There are hedge fund managers making nine figures per year (that’s hundreds of millions). Anyone in that atmosphere can hire the few experts who could understand a 6,328-word code section.

I support a more fair treatment of carried interests for those living in the penthouse of equity gains. I work with a lot of real estate investors who also have carried interests, but who (relatively) occupy the basement. We have many tax laws that apply only to “large” taxpayers. New plans are for corporate tax increases for those with $1 billion or more of profits. Other provisions apply to those with $25 million or more of gross receipts.

The carried interest question has stayed in tax legislators’ sights because of the large profits earned by hedge fund and private equity managers.

We should be asking, does your hedge fund manager bite? Let’s muzzle those who do. The real estate guys I see are not those managers.

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.

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