Wednesday, June 5, 2019
Forbes Magazine has a short but interesting piece on how fund managers get an even bigger tax break when they use income from a carried interest to make a charitable contribution. Here is an excerpt:
Imagine a private equity investment fund with a standard “two and twenty” arrangement whereby the manager receives an annual fee equal to 2.0% of the capital plus a "carried interest" equal to 20% of the profits. Most funds—even those with mediocre overall results—usually have at least a few very successful investments into private companies that are later listed on the stock market. For the sake of illustration, let’s assume that the fund invested into a private company—call it “HomeRun” Inc.—that is later listed on the stock market at a valuation many multiples of the fund’s initial investment.
In this case, the manager would likely receive some of his (the vast majority of private equity partners are men) carried interest in HomeRun shares rather than cash. (In private equity speak, he would receive a “distribution” of HomeRun shares.) While the manager still pays tax (at the 20% capital gains rate) on the carried interest he receives in HomeRun shares, it is only due when he sells the shares. This leaves him the option of giving them away instead.
Let’s say it’s the 25th anniversary of his b-school graduation and he wants to give $1.0 million to his alma mater. Were he a normal, working person (e.g., a doctor), the $1.0 million gift would come out of his ordinary income with the associated charitable deduction offsetting the taxes he would otherwise have to pay. (Based on a top marginal federal tax rate of 37%, the deduction would reduce his taxes by $370,000 making the public a de facto 37% partner in his gift.) In order words, the public has agreed—through the tax code—not to tax him on the income he gives away.
The private equity manager can do much better. Instead of cash, he gives his alma mater $1.0 million in HomeRun shares. Because he gives the shares away without selling them, he never has to pay the 20% tax ($200,000) that would otherwise have been due. (His college doesn’t pay the tax either since it’s a nonprofit.) At this point, the private equity manager is no different from the doctor; he has made a gift without paying the tax (in his case, at 20%) making the public a de facto 20% partner in his gift. But here’s the rub: he also gets to claim the $1.0 million gift as a deduction against his income.
Assuming a federal rate of 37%, this deduction is worth a further $370,000 making the public a $570,000 de facto contributor to his $1.0 million gift. The public is a silent, unwitting, 57% partner in his giving. (This is just the federal analysis; the public contribution would likely be more after considering state-level taxes). Said another way, for every $1.00 he gives away, the public—through the tax code— waives the taxes and gives him a further $0.37 bonus.
This is not a theoretical exercise. Everyone who receives carried-interest in the form of low-basis stock knows how the math works and so do their financial advisors. In fact, much of the giving by wealthy people with carried interest income is likely made through gifts of stock.
I question whether the fund manager can avoid all tax by "giving the stock away" instead of selling it (the bold and italicized sentences in the quote above). I have not looked at the Subchapter K rules in awhile, and don't have time now, but it seems to me that donating the stock ought to constitute a recognition event. Still, even if the donation triggers tax, the fact that the stock is taxed at capital gains rates to the fund manager, and then used to offset ordinary income, to the extent of the stock's fair market value, is just insult to injury for the rest of us.
Darryll K. Jones