Saturday, July 14, 2007


Senator Clinton might want to consult TurboTax

Senator Clinton has jumped on the latest tax-hike bandwagon:

“Hillary Clinton today announced her support for cracking down on the tax loophole that allows some Wall Street investment managers to pay dramatically lower tax rates on their income than those paid by average working Americans. Current tax laws allow investment managers in certain partnerships to take large amounts of their compensation in the form of "carried interest," which is taxed at the low 15% capital gains rate, rather than at income tax rates as high as 35%.” - Media Release

Of course, the classic definition of a loophole is a tax benefit not available to you. Here, I honestly don’t believe Ms. Clinton knows enough about this issue to effectively discuss the mechanics of how partnerships are taxed. In fact, I doubt Ms. Clinton really has much of a grounding in the mechanics of our tax system as a whole. I state this because of this piece of red meat she shoved out to her peeps:

"It offends our values as a nation when an investment manager making $50 million can pay a lower tax rate on her earned income than a teacher making $50,000 pays on her income.”

I’m sorry but that just doesn’t make any sense. Let’s assume our $50,000 a year teacher is married, filing joint and her spouse is also making $50,000 a year. They have no children. I’m also going to assume they have deductions of $20,000 ($12,000 for mortgage interest, $5,000 for state income & property taxes and $2,000 for charitable). That brings their income down to $80,000. Now we can deduct their personal exemption of $6,600 ($3,300 each) and we arrive at taxable income of $73,400. Their tax on that would be $11,465 or an effective tax rate of 11.465% (although they are in the 25% tax bracket for each additional dollar earned).

[Ed. Note: Even if they have no deductions and instead use the standard deduction of $10,300, their effective rate is still less than 14%]

Now look at our $50,000,000 hedge fund manager. Similar scenario only we’ll assume the spouse doesn’t work – he’s a bum who hangs out at the country club trying to break 90. Usually, these managers will make some earned income off the value of the investments being managed so if you’re pulling in $50,000,000, you’re probably managing a rather sizable fund. So it’s not unreasonable to assume she is pulling in at least $336,551 of earned income which puts her into the 35% tax bracket for earned. Because of her overall income, her exemptions and deductions are phasing out (if not phased out) meaning she has little shelter on any of her income. Her effective tax rate will be at least 15% because she’s paying on that huge Cap Gain plus the incremental on her earned income.

Bottom line, the $50,000 school teacher’s spouse would have to make approximately $85,000 (with no change in deductions) before they would approach the 15% effective tax rate. And it’s the latter couple that has an AMT worry…

There may be policy arguments for changing income characterization – although I default to the “no new taxes” position – but once again Ms. Clinton’s turn to demagoguery has me thinking she just isn’t as serious and knowledgeable as she is so lovingly portrayed.

Clinton was sloppy and her daughter, who works for McKinsey, could have told her that she was being sloppy.

A stronger argument, though perhaps not a winning one, is that favorable capital gains rates are designed to promote the liberation of dormant underproducing assets into the productive market deployment that would otherwise not enter the market, often out of a desire to wait for a stepped-up basis at death for family-owned assets. Fund managers are more similar to lawyers and doctors than to the owner of "Blackacre Farm."

Their own investment in their funds is more similar to the return that a licensed professional gets from his long hours and sweat and the capital he or she invests. That income, that gain, is ordinarily treated at regular rates and the IRS looks askance at attempts to "over pay" for a partnership interest on a buy-out in lieu of salaries taxed at ordinary rates and, of lesser concern, under FICA.

A somewhat analogous example: a Seattle attorney attempted to claim that his professional S corporation profited mid-6 figures and that his own salary, less favorably taxed, was $1.00 a year. The IRS, opining that he was worth more than $1/year since he was the only employee, taxed the entire profit as salary, and kicked him with brutal penalties. Similar reasoning might seem appropriate if the figures have 8 digits rather than 6. What do you think - more your bailiwick than mine?
that Seattle attorney couldn't have been advised by anyone with more than an H&R BLock education - S Corp's and Professional Corporations are scrutinized for just this kind of mischaracterization...the general rule is don't get Piggy about avoiding taxes.

...and I don't think it corresponds to this situation because the underlying form of income being allocated to the manager is Capital Gain (selling of Capital Assets)
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