Be careful what you ask for in Clinton-Trump tax reforms

Politicians love a good sound bite. They are short, memorable and, more often than not, easily understood. When candidates or commentators discuss immigration, the second amendment, or any of a host of other topics, we (that is, the general public) usually have a pretty good grasp of the relevant buzzwords and topic du jour, at least enough to make an informed decision as to what we believe and whom we want to support. However, there is one hot-button issue teeming with buzzwords that does not have the innate clarity of these other sound bites. I am, of course, referring to taxes. Consider the following, which are (or very well may have been) headlines from the past several months:

“Clinton vows to close carried interest” 

“Donald Trump’s tax plan goes after corporate inversions.” 

{mosads}Politicians can safely take aim at “tax loopholes,” knowing that just the mention of one is enough to make our blood boil. However, many, if not most, do not actually know what constitutes a carried interest (it’s how Wall Street avoids taxes … right?) or a corporate inversion (it’s how corporations avoid paying any taxes, right?). Rather than take a partisan position, the objective of this article is to help demystify what candidates and commentators mean when they stray into the murky waters of tax law. 

Carried Interest

Both Donald Trump and Hillary Clinton have pledged to close the “carried interest” loophole. So what is a carried interest and why should we be outraged that it exists? Simply, a carried interest reflects the portion of an investment’s profit that is kept by the investment advisor (you can think of it as the advisor’s share of the winnings). Carried interests are most common in the fund context (private equity funds, hedge funds etc.) and are generally referenced in conjunction with the fund’s management fee, such as a “2 & 20.” That means that the fund will charge an annual management fee of 2% of the fund’s principal, and that the fund managers receive a 20 percent carried interest from the fund’s profits. Imagine the following example:

Mortimer and Randolph Duke run a hedge fund (structured as a 2 & 20) investing in orange juice futures and Billy wants to invest $1 million in their fund.

(i) In the first instance that Mortimer and Randolph invest Billy’s $1 million and ultimately sell their investments for $1.5 million (that is, for a $500,000 profit). Billy is repaid his $1 million investment and the profit is split 80% to Billy ($400,000) and 20% Mortimer and Randolph ($100,000, i.e., the carry). Everyone, Billy, Mortimer, and Randolph, is subject to tax on the profit at preferential long term capital gains rates (after all, the profit reflects a $500,000 return on the $1 million investment). 

(ii) Alternatively, imagine that Mortimer and Randolph, while investigating the orange juice futures market, got some bad information on the market from Louis. They invest Billy’s $1 million, the investment loses money, and is ultimately sold for $200,000. Billy gets all $200,000 and has an $800,000 capital loss. Mortimer and Randolph receive nothing for their carried interest.

The “loophole” is that the 20% carry looks a lot like compensation to Mortimer and Randolph for services rendered as investment advisors/fund managers. While most of us are subject to ordinary income tax rates on our compensation, a fund manager’s carry is eligible for long-term capital gains treatment (which can be close to half the ordinary income tax rates). However, while most people they can reasonably expect a paycheck every 2 weeks, regardless of the company’s success, a carry, in many respects, looks and feels a lot more like an investment. Indeed, private equity managers often argue that (i) the carry only pays if the investment is successful and goes up in value and (ii) they may only realize that value 5 or 6 years after the investment is made. Further, taxing the carry at ordinary income rates (rather than preferential long-term capital gains rates) would mean taxing different partners in the same partnership differently. 

So, is a carry merely compensation to a fund manager that should be taxed the same as your paycheck, or do the fund managers have more at risk with their carry, rightfully classifying it as an investment that deserves long term capital gains treatment? Hopefully you can now make an informed decision that is in line with your beliefs.

Corporate Inversions

Many prominent politicians from both sides of the aisle have questioned the fairness of corporate inversions. The rhetoric around corporate inversions, on both sides, is passionate, and the proposals have significant consequences. So, what is an inversion? How are corporations leaving the U.S. and avoiding their tax liabilities?

Understanding corporate inversions requires understanding a basic philosophy of U.S. income tax. On one hand, the U.S. imposes income tax on the worldwide earnings of U.S. corporations, regardless of where that income is earned. While safeguards exist to make sure that U.S. corporations do not pay tax on the same income twice (that is, both in the country where it is earned and in the U.S.), the fact that the U.S. has one of the highest corporate tax rates in the developed world means that a lot of foreign earned income is subject to U.S. income tax. On the other hand, foreign corporations doing business in the U.S. are only subject to U.S. income tax on their income actually earned in the U.S. The impact of worldwide taxation (and why corporations may want to “leave” the U.S.) can be seen in the following example:

Assume the U.S. corporate income tax rate is 35 percent and the Mexican corporate income tax rate is 30 percent. 

(i) ACME, Inc. is a U.S. corporation with business operations in Texas and Mexico. In 2016, ACME, Inc. earns $1,000 from its Texas operations and $1,000 from its Mexican operations. ACME, Inc. must pay $350 of tax to the U.S. for its Texas operations, $300 to Mexico for its Mexican operations, and $50 to the U.S. for its Mexican operations. In total, ACME, Inc. pays $700 in taxes. 

(ii) Alternatively, if ACME, Inc. is a Mexican corporation, with all other facts remaining the same, in 2016 ACME, Inc. will pay $350 to the U.S. for its Texas operations and $300 to Mexico for its Mexican operations. In total, ACME, Inc. pays $650 in taxes.  

When a U.S. corporation inverts, it moves its place of organization from the U.S. to a foreign jurisdiction. As a result, the corporation only pays U.S. income tax on income earned in the U.S. and not on its worldwide income, which can significantly reduce its worldwide effective tax rate. To be clear, when a corporation inverts into a foreign jurisdiction it does not usually eliminate U.S. jobs. Rather, the inversion is a classic case of “paper shuffling” and changing the place where annual registrations are filed. 

When evaluating an inversion, consider the corporation’s obligation to its shareholders to maximize profit vs. its obligations to the U.S. as a corporate citizen. If you buy stock in a corporation, would you, as a shareholder, accept an explanation that the share price was lower than it could be because the company did not take every possible step it could to minimize taxes? Or, would you be proud that you owned stock in a company that stayed “onshore”? Should we focus on treating the cause (that is, corporate tax rates that incentivize corporations to look for inversion opportunities) or accept our tax law as is and focus on treating the symptom (that is, patching the inversion “loophole”)?   

Concluding Thoughts

This article should be read with a grain of salt. There are tax practitioners who dedicate their entire careers to analyzing, evaluating, and structuring carried interests and inversions. It would be foolhardy to think we could accomplish anything other than a 60,000 foot flyover in our time together. But, I do hope that this article sheds light on two of the buzz words (or buzz phrases, as the case may be) that have become ubiquitous in this election cycle, that is, “carried interest” and “corporate inversions.” 

Think about your annual exercise of preparing and filing your personal tax or business return. I imagine that you take advantage of every deduction available, and (within the confines of the law) strive to minimize your tax bill. That is consistent with the words of Judge Learned Hand (yes, that is his name, and yes, it is an incredible name for a judge), who famously proclaimed that “anyone may arrange his affairs so that his taxes shall be as low as possible . . . for nobody owes any public duty to pay more than the law demands.” With that in mind, it is important to remember that carried interest and corporate inversions are currently 100% legal. Whether they remain legal and as advantageous from a tax perspective is the province of us, the voters. 

Richman is Senior Counsel in the Corporate Department of Seyfarth Shaw LLP’s Atlanta office, where he primarily focuses his practice on navigating the intricacies of corporate and partnership taxation.

The views expressed by Contributors are their own and are not the views of The Hill.