In film, it’s called “deus ex machina” or god from the machine. When heroes find themselves painted into a hopeless corner from which seemingly nothing can save them, an implausible plot twist saves the day. In the original Superman movie, for example, Christopher Reeve’s Man of Steel sees Lois Lane killed by a devastating West Coast earthquake and suddenly remembers that he has the capacity to turn back time by flying around the earth so fast that it temporarily starts spinning backward.
Equally unexpected, and substantially less lame, is the latest development in the endless saga of tax avoidance by hedge fund and private equity managers. The Internal Revenue Service proposed new rules last Wednesday that will make it harder for money managers to disguise their ordinary income as capital gains. That’s right. After years of congressional inaction on hedge fund tax avoidance, the IRS, like Superman, has suddenly remembered that it has had the power to solve this problem all along.
To be clear, the new IRS rules can only solve a small part of the problem. Hedge fund and other investment partnership managers are often paid under an arrangement known as “two and twenty". Managers receive a 2 percent fee for assets under their management, and later get 20 percent of any profits.
The managers of these partnerships have come up with strategies for avoiding taxes on both the 2 and the 20. On the 20 they get the tax break we know as “carried interest,” through which hedge fund managers brazenly classify their share of the partnership’s profits as capital gains income, despite the fact that the money they’re investing doesn’t even belong to them. The top tax rate on capital gains is lower than the top tax rate on ordinary income, which is why these wealthy fund managers seek to classify as much of their income as possible as capital gains.
What the IRS dealt with last week is the 2, the management fees, which private equity firms have also found a way to convert into capital gains. The scheme here is certainly less gripping than Lex Luthor attempting to destroy California, but it is just as obviously wrong that private equity managers take their management fees, clearly a payment for service that should be taxed as regular income, and pool them into a fund that generates income they can describe as capital gains. This results in huge tax savings. This crafty accounting has fooled no one, and—finally–the IRS is calling these alleged capital gains what they are: “disguised payment for services.”
This isn’t the end of the story, however. Affected parties can submit comments to the IRS during the next several months on suggested modifications to the new IRS rules. Expect those who benefit from these tax loopholes to submit comments arguing why the IRS shouldn’t tighten its rules. Yet it seems highly unlikely that hedge funds and private equity firms will be able to use this tax dodge with impunity going forward.
This leaves the interesting question of whether the IRS can also deal with the much larger problem of carried interest, or the 20 percent of profits that money managers earn if and when an investment becomes profitable. While the profits are indeed capital gains for the actual investors, the money managers (who don’t have to invest a single cent of their own money in the venture) get a share of the profits because of how the deal is structured, thus their share of profits is income in the same way that the money that individuals pay to financial advisors is income.
President Obama, CTJ and other groups have called for legislation to close this loophole, but Congress has repeatedly failed to act. Last year, however, the respected tax professor Vic Fleischer argued in the New York Times that the Obama Administration could close the door on the carried interest loophole through administrative action, just as the IRS has proposed to do with the 2 percent management fees.
It would be more pleasing if Superman could save the world in a plausible way, just as it might be better to see the carried interest loophole closed through legislation. But the current ruling party in Congress is utterly uninterested in doing so. So it would be more expeditious if the IRS has another epiphany and recognizes that it has the power to solve the entire problem on its own.