Saturday, July 28, 2007

Taxing carried interest as ordinary income - an awful idea Congress should not "promote"

A bill has been introduced in Congress (HB 2834) that would change the way many real estate developers -- most of whom are entrepreneurs -- would be taxed.

Okay, you may ask: what is carried interest? Better known in my circles as a "promote," carried interest is the percentage of a deal involving a venture that the developer takes as compensation, usually through a limited amount of capital investment and a lot of sweat equity.

Often what happens in a development deal is this: The developer (or "promoter") hooks up with a party with funds to invest (the so-called "money partner"). The parties reach an agreement on how the profits from an investment are to be split.

Without boring you with too many details (you can hire me if you want more), when the deal is done (or maybe when there is a financing that allows the members to take cash out), the first dollars go to the money partner, which gets its money back plus a preferred return, after which the profits are split according to a deal-specific formula. Almost always, the more profitable a venture is, the larger the promote for the developer, even with little or no money of its own in the game.

The current law is that the promote is taxed as a capital gain, which has a much lower (15%) tax rate than ordinary income. The bill seeks to tax promotes as ordinary income.

This is in my opinion a bad idea on so many levels. I won't get into all of them here, but the ones I hate the most are as follows. First and foremost, this tax will discourage developers from taking risks. I think a calculated risk is a good thing and ought to be encouraged. Marginal deals, even creative ones or maybe ones that preserve buildings or have character, may not get done. The added problem is the trickle-down. The fewer developments, the less construction, meaning less work for all the people down the ladder.

While I think the best solution is no tax at all, if the concern is to make sure the super-wealthy are not taxed in their entirety at the capital gain rate (Warren Buffett talked about that recently, I believe), then consider taxing carried interest above a certain threshold at the higher rate. There might be loopholes to close (e.g., the use of multiple entity structures to limit promotes below a given threshold), but it protects the smaller developers and encourages them to continue to take the risks that often lead to the most interesting transactions.