Dear Mr. Berko: Please explain carried interest, which some of the presidential candidates are talking about. I know it has something to do with hedge funds (and I’m not sure what hedge funds are) and is taxed differently than interest I get from my Fidelity bond fund. What’s the big deal about this?
— P.D., Minneapolis
Dear P.D.: Hedge funds are mutual funds on steroids and immune to most of the Securities and Exchange Commission’s enforcement rules. Hedge funds are like open pit latrines, fouling every room they’re in. Hedge funds manage money for the very rich so the very rich can make even more money. Managers move money around using exotic algorithms, computer-driven trading programs, complex option positions and other strategies in hopes of generating enormous yields. And those yields must be double- and triple-digit returns because the wealthy who use those latrines believe it’s their entitlement. Hedge funds contribute nothing to our gross domestic product.
Hedge funds are playthings for the rich, and the rich on Wall Street are not subject to the same rules as those of us on Main Street. So at the close of 2014, wealthy Americans had about $2.6 trillion invested in hedge funds, which is an average of about $8,000 for every U.S. citizen. And one of the best reasons for managing a hedge fund is that most of the enormous fees earned by the general partners (managers) are not taxed at the maximum 39.6 percent rate. Rather, those fees are treated as a business investment and taxed at the long-term capital gains rate of 20 percent. So the 25 fortunate hedge fund managers who each took over $1 billion in fees in 2014 only paid $200,000 in taxes on each billion. Now there are 7,716 hedge funds, and those managers who only made a few hundred million in fees also paid 20 percent in taxes. If these guys paid taxes like real Americans, the Treasury would have been richer last year by $18 billion. Read on.
Hedge fund managers have a fee structure that’s called a 2-and-20. The general partner takes 2 percent of the fund’s total market value as a management fee. Then, at the end of the fiscal year, the GP earns an additional 20 percent of all gains earned over a benchmark index, such as the Standard & Poor’s 500 index, the Russell 2000 index or the U.S. Treasury bond index. The 2 percent is taxed as ordinary income at 39.6 percent, whereas the 20 percent fee that accrues to the GP as an incentive is deemed carried interest and taxed at the long-term capital gains rate of 20 percent. Carried interest is not interest income like one receives from a bond. Rather, it’s a claim of the GP or manager for performance. Powerful lobbyists in Washington persuaded Congress to characterize the carried interest fee as capital gains rather than a fee for services. And during election time, we can be sure as shootin’ that the super PACs controlled by members of Congress will debouch with tens of millions of hedge fund dollars. And those donations are so sweetly deductible.
