Putting a Bull’s-Eye on a Tax Loophole

From The New York Times:

Tucked away on Page 122 of President Obama’s budget is a proposal that has the fast money crowd up in arms: “Tax carried interest as ordinary income.”

It sounds like something only a certified public accountant would care about. But in fact, the Obama administration wants to close one of the biggest tax loopholes on Wall Street — one nobody seemed to notice in good times, when everyone was minting money.

As things stand now, private equity firms and hedge funds get a much better deal from the taxman than the rest of us. They are taxed at a mere 15 percent — the capital gains rate — on most of their income, instead of the higher regular income tax rate. For the past two years, they have scrambled to keep it that way. And with the economy swooning, the industry was hoping lawmakers might just forget about this little tax giveaway.

How do they justify it? Private equity types and other investors argue that they’re in the business of investing, so they should be taxed like investors who make money in the public markets. The “carried interest” in question — the bulk of these firms’ profits — refers to the 20 percent cut of profits they take when they sell, or exit, investments.

This tax deal always struck a lot of people as a little too sweet. One study commissioned last year by a Congressional committee estimated that executives would save $30 billion in taxes over the next 10 years if the rules did not change. (Of course, that was before the financial crisis began.) Buyout firms and their executives have some skin in the game, but mostly they invest using other people’s money, like pension funds. So their 20 percent cut of profits is closer to a commission than a true capital gain.

Warren E. Buffett has pointed out that this tax treatment has enabled ultrawealthy executives to pay a lower tax rate “than our receptionists do or our cleaning ladies.” (I know, I know: many people believe Mr. Buffett has managed to avoid taxes too, in part by giving away his fortune to charity, but that’s beside the point.)

And Robert E. Rubin, the former Treasury secretary who was a senior adviser at Citigroup, has also been a sharp critic.

“You can characterize it as a performance fee, you can characterize it as a carried interest, you can characterize it any way you want,” Mr. Rubin said in a controversial comment in 2007. “I think at the core there is a very good argument to be made for treating this as ordinary income.”