Just another word for evil, I guess, from all the bad press it’s getting. Even Donald Trump says he’ll kill the dragon of “carried interest” if he becomes president. The term used to mean something distinct and exact but lately is loosely used to cover a lot of things it never used to mean. For example, the New York Times describes it this way:
Carried interest is the percentage of investment gains that hedge fund managers, private equity executives and venture capital partners take as compensation, usually in addition to a management fee. (“Two and twenty” has become Wall Street jargon for these funds’ typical compensation scheme, meaning 2 percent of assets under management and 20 percent of any gains.) Because the “carry” is tied to performance, it is treated like an investment and subjected to the lower capital gains tax rate, rather than as ordinary income, even though most managers don’t put any of their own money at risk.
This is almost but not quite what a real carried interest is, but it’ll do for purposes of this discussion. The thing to focus on here is that those who don’t like it call it a tax “loop hole,” because it’s way to pay capital gains tax rates on gains they claim are in reality ordinary income. It’s actually not a loop hole at all. It’s Section 83 of the Internal Revenue Code. It’s been in the law for decades.
Section 83 applies to Property transferred in connection with performance of services. Say I shovel snow off your walk after a December snow storm and you pay me $25. I have ordinary income of $25 and I may owe income tax at ordinary income rates. But say you entice me instead with a promise to give me 25% of the profits of your daughter’s lemonade stand next July. Assuming your daughter agrees I might do some quick calculations of what I believe the demand for lemonade at that street corner will be next July. If I believe the total profits will be enough to give my 25% interest a sum sufficiently greater than $25 I may agree to accept that interest in lieu of immediate cash.
Section 83(a) says I have to include the fair market value of my interest in your daughter’s lemonade stand in my income for the first taxable year in which the interest is transferable or is not subject to a substantial risk of forfeiture. Assuming you placed no restriction on my right to sell the interest, I might have to include its value in income for the current year.
I’m not going to actually receive any money until next year, that is if I ever receive any money at all. Your daughter’s lemonade stand may not be successful. It may not even ever exist. Your daughter is 8 years old, not the most reliable partner I could have. So I may have to pay income tax this year on money I may never receive? Not fair, I say!
The Congress that enacted Section 83(a) realized that this idea of taxing property for services performed could work a hardship in some cases. So they also enacted Section 83(b). That subsection says that I may elect to include the value of my interest in your daughter’s lemonade stand this year, or I may decide to defer it until next year when I will actually receive the cash, that is if I ever do receive any cash from the the future efforts of an unreliable partner.
I probably would elect to have it taxed this year because its future value is highly speculative making its present value pretty low. Even my brother in law is not going to be willing to give me more than 5 or 10 dollars for it. So, I will make the election that I am allowed by law to make under section 83(b) and include $10 in income for this year and pay tax on that amount.
Say my 8-year partner is an industrious little girl and earns $400 in profit from her lemonade stand next July, and my 25% share is $100. Cool, I’m sure glad I elected to may that 83(b) election because my $100 share of profits, minus my basis of $10 I got by declaring that as income in the prior year, is now treated as a capital gain and not as ordinary income. I will show a $90 capital gain on my Schedule D for the year.
Alas, because December this year is less than a full year until July of next year, my gain will be short term rather than long term, so if that’s all the gains and losses I have I won’t save anything in overall taxes since short-term gains are taxed at ordinary income rates. But let’s say I have a long-term built-in loss in another property I own. If I sell it in the same year so that I realize that loss I can use it in the capital gains and losses hotchpot to offset that short-term gain from the lemonade stand. If the long-term loss is at least $100 it will completely offset my short-term gain and I will owe no taxes for it. Way cool.
Have I slithered throw a tax loop hole? No! I have simply followed the law that is entirely reasonable and has been on the books for decades. It’s not a loop hole, it’s a statute passed by our elected representatives in Washington.
By the way, what if my 8-year old partner had decided to go to camp for the summer instead of setting up a lemonade stand? Remember, I paid taxes on that $10 which represented the value of what I got back in December. Can I now declared that as a loss and get back the taxes I paid? No, the 83(b) election, once made, is irrevocable. I paid income taxes on a dead horse. That’s the breaks.
The New York Times claims hedge fund managers have none of their own money at risk. I took a small risk with the lemonade stand. You’d need to add about a dozen zeros to my numbers to measure the risks that are taken by hedge fund managers and other high dollar players in the financial markets who are making deals in reliance on the current tax laws, including Section 83.
They are doing nothing wrong. They are simply following the laws that have been in existence for a long time, and those laws make sense. There is no reason for Donald Trump or anyone else to single these people out for draconian tax increases which will do nothing but diminish economic activity that benefits millions of people in the long run.
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