Taxation of partnerships is one of the more arcane subdivisions of the US federal income tax law, one which I've been wrestling with for nearly 40 years. Consequently you can imagine my surprise when the topic effectively becomes the headline news story in the newspapers and the lead story on the television news, causing such a fallout such that the publicity may trigger a change in the tax law. However, it comes as no surprise as how the press has so incorrectly described these rules, and in so doing likely turning public opinion against what really are reasonable tax laws.
The story begins with Mitt Romney releasing his 2010 income tax return showing some $20 million of income and $3 million of tax paid, with an effective tax rate under 15 percent. Now if you earn $20 million in a year, you would pay a marginal tax rate of 35 percent on your wages, interest income, or rental income, but only 15 percent on your dividend income or capital gains. Obviously most of Romney's income fell into the latter categories. Personally I don't see why dividends should be taxed at 15 percent while interest income is taxed at 35 percent. But that's not where the press has focused its attention. Rather, it is the 15 percent rate on Romney's capital gains income from his hedge fund investments (known as "carried interests") that is taking all the flak.
Now the beef doesn't seem to be with the 15 percent capital gains rate per se. Rather the beef is with granting hedge fund owners the ability to treat their income as capital gains using a special tax loophole specially designed to benefit just a privileged few in the hedge fund industry. Now what is annoying is the statement we hear on the news (by financial reporters, no less) that the tax rules that Romney benefited from were a loophole created for the benefit of hedge funds. This is patently ludicrous. As far as I can tell, the tax rule in question goes back to the 1920s, while I don't think hedge funds were even invented until the 1990s, so characterizing this is a special break created for hedge funds is absolutely ridiculous.
Furthermore, by no sense of the imagination can the rule be considered to be a loophole, as can be demonstrated by the historical application of the rule. The classic example of the rule in action arose nearly a century ago out of the real estate industry. Historically, real estate has often been developed under a 50-50 deal--a taxpayer with real estate expertise partners with a money investor to develop property, such as an office building, in an equal partnership. After a period of many years, the parties eventually sell the office building, obviously for a capital gain, and split the profits. To the taxpayer who contributed the development expertise to the partnership, his interest became known as a carried interest. In today's hedge fund world, the office building is replaced by stock of a corporation, which is a capital asset, just like an office building that is held for investment. There is certainly no loophole here. While it is true that the real estate partner received an element of capital gains for services, most of his profit is attributed to the subsequent holding of the asset for appreciation. This isn't much different from corporate executives who are highly compensated by stock options, which likewise give them a large element of capital gains income when their optioned stock subsequently appreciates in value and is eventually sold.
Now the Obama administration has twice attempted to repeal the so-called carried interest rule. However those attempts were thwarted by Congress, led in particular by those right wing Republican protectors of the wealthy, Senators John Kerry of Massachusetts and Chuck Schumer of New York. Wait--Kerry and Schumer are liberal Democrats. If this was really a loophole for rich hedge fund managers, would they be leading the opposition to the repeal of the carried interest rule? And does that mean there is more than meets the eye, and that the press characterization of the issue isn't particularly accurate? I'll let you figure that out.