New York State Attorney General Investigating Tax Practices of Hedge Firms That Convert Ordinary Income (High Tax) into Capital Gains (Low Tax)

But Nobody Knows Why

Literature is not the only source of mysteries, sometime tax and finance provide similar stories.  Except in many cases both the reader and the characters are clueless.  Such is the case in the recently announced actions of New York Attorney General Eric Schneiderman to investigate tax practices among hedge funds.

Fred R. Conrad/The New York Times

Eric Schneiderman subpoenaed more than a dozen firms seeking documents that would reveal details about their tax strategies.

The issue at hand is whether or not the firms engaged in tax fraud by waiving their management fees in return for a higher investment stake in firms they invested in, thus turning the income into capital gains.  On the surface it appears this is exactly what they are doing, in fact, it appears to be rather well known.

Managers at a typical private equity firm or hedge fund collect from their investors management fees based on the size of the fund. But most of their compensation comes as a share of the profits earned by the fund. The Internal Revenue Service allows those profits to be considered “carried interest,” taxed at the capital gains rate typically reserved for investments.

The tax strategy used by Bain and other firms to convert management fees — the compensation normally taxed as ordinary income — into capital gains is known as a “management fee waiver.” The strategy is widely used within the industry: 40 percent of the 35 buyout firms based in the United States surveyed in 2009 by Dow Jones said their partners used at least some of the firm’s fees to make investments in their funds.

As for the strategy itself, it is clearly a violation of the tax laws, since the income from the management fees is taxable income even if it is exchanged for higher participation. (It would take a tax expert to fully explain all this, fortunately The Dismal Political Economist is a tax expert.  Even better, he is not going to explain all  this.)  The fact that some hedge funds don’t do this at all is proof enough that it is wrong. People that run these funds are the greediest people in the world, if it were even potentially legal every fund would be doing it.

So what’s the mystery?  It is this.  Why is the Attorney General of New York involved here.  New York state is one where there is no preferential treatment for capital gains.  This means that the strategy has no effect on New York taxes.  And it is the Feds, not New York state that enforces federal tax laws.  In short there appears to be absolutely no rationale for the Attorney General of New York to be involved.

To solve this mystery we went to the end of the book to see ‘whodunit’.  But unlike fiction, real life doesn’t have a book, so we still do not know.  On the other hand we do know why the IRS is not on the case, too much political heat, you know, attacking the wealth creators.