Senator Sinema and Carried Interest

August 17, 2022

Political Malfeasance in Action

U.S. Senator Kyrsten Sinema (D-AZ) received nearly $1 Million in Wall Street contributions while killing a tax hike on certain Investment Bankers.

I grew up in the 1960’s in Buffalo, NY where it seemed that candidates for election to public office couldn’t get nominated until they could prove their ability to attract illegal political contributions. Over my professional career, I spent significant time in other northeast states, counties and cities where political corruption was often the norm.

Most of the corrupt elected officials I observed were guilty of getting their driveway paved; their house painted; maybe a new roof. Not good, not appropriate, and certainly, not acceptable.

The recent behavior of Sen. Kyrsten Sinema (D-AZ) relative to the Carried Interest federal tax loophole puts the actions and behaviors of these historic elected officials in NY and CT into the category of ‘fixing parking tickets’.

The despicable and nefarious posturing by Sen. Sinema has blessed Carried Interest, sometimes known as ‘the cockroach of tax breaks, allowing it to survive another potential assault by Congress.

The proposal to increase the holding period requirement to qualify certain income paid to investment bankers for the lower Carried Interest tax rate was removed from the landmark ‘Inflation Reduction Act’ of 2022 (H.R. 5376) recently passed by both the Senate and the House and signed into law by President Joe Biden on August 16, 2022.

The “compromise” to remove Carried Interest was demanded by Sen. Kyrsten Sinema (D-AZ) which she justified on a complex and convoluted set of criteria, and which potentially might be related to the $1 Million in campaign contributions she received over the past year from private equity professionals, hedge fund managers and venture capitalists whose taxes would have increased exponentially under the original plan.

The concept of Carried Interest dates back to the 16th century, when ocean-going ship captains would often take a 20 percent “interest” of whatever profits were realized from the cargos they carried. This approach is logical and defensible on the risks to life, property and personal capital undertaken by ship captains.

In 21st century America, the meaning of Carried Interest has evolved to describe a tax loophole — an income tax avoidance scheme — which allows some private equity and hedge fund investment bankers to classify large amounts of their compensation related to performing services (i.e. managing and/or investing other people’s money) as investment gains, which substantially lowers the amount they are required to pay in taxes.

Today’s Carried Interestis essentially a payment (bonus or commission) for investment services that is taken out of the profits of the money managed for investors. Private equity firms use pooled money from large institutional investors (pension funds, college endowments, ultra-high net worth individuals, etc.) to acquire controlling interests in struggling, underperforming or undervalued companies. When the investment are made, these acquired entities agree to pay the private equity firms Carried Interestout of the investment profits on top of management and other fees.

Under our current tax law, when the carried interest income is paid out of the private equity firm to individual partners, directors, etc. it is taxed at the preferential (‘capital gains’) rates granted to investment income, even though the income represents compensation for services. In all other contexts, compensation income – salaries, bonus, commissions, etc. – is taxed everywhere else as ordinary income.

Investment professionals often are required to contribute capital if they are eligible to receive carry, although it varies by firm and by position in the hierarchy (from 23% of associates/senior associates to 71% of managing partners). Essentially, the Carried Interest tax loophole acts as a magic wand to turn ordinary compensation income into preferentially-taxed capital gains income for a few thousand specially entitled individuals each year.

Private Equity (“PE”) is a $4.5 Trillion industry which tends to follow a predictable model: Use very high levels of debt to take control of underperforming (or undervalued) companies and then extract as much value as possible over a short- to intermediate time frame.

One of my favorite movies, “Other People’s Money” (1991: Warner Brothers [directed by Norman Jewison]; starring Danny DeVito and Gregory Peck) almost perfectly illustrates the potentially powerful impact of leveraged debt strategically deployed against a weak management team. In the film, the end result is: (a) closure and liquidation of New England Wire & Cable Company, a boring multi-generational family manufacturing business; (b) the loss of hundreds of decent jobs in a small American city; and (c) millions of dollars of ‘pirated booty’ transferred to anonymous private equity investors, with a mighty fine Carried Interest reward paid to Danny DeVito (the investment banker).

Zero value added to the overall U.S. economy.

Devastating value lost to a small American city, its residents and the regional economy.

Sure, the investment banker (Danny DeVito) took home a fine bonus. He probably was able to buy a nice airplane and maybe a vacation home in the Hamptons.

Meanwhile, the wire and cable products formerly supplied by the now defunct domestic company now are being sourced from a foreign firm. The American city where the former Wire and Cable business was located lost tax revenue which had formerly been used to support local schools and public works. And, local families abruptly lost their incomes, and their homes potentially went into foreclosure.

Most alarming: U.S. taxpayers subsidized the whole mess because of this crazy, foolish and irrational tax break known as Carried Interest.

Some will say that the movie, “Other People’s Money” is a 1991 dinosaur which has no relevance in 2022.

Yet, the devastation continues. In our current environment, retailers are particularly vulnerable to leveraged buyouts, and they provide the most visible examples of companies which have been acquired, pillaged and wrecked by private equity firms.

In January 2020, the New York grocery chain Fairway filed for its second bankruptcy in less than four years and announced plans to sell off its stores, due to several efforts by PE firms to extract value from the franchise. The Fairway failure joins a long list of casualties that includes: Sears; Toys R Us; Payless ShoeSource; and Sports Authority, among many others.

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In theory, PE firms snap up underperforming companies using ‘patient capital’; they bring in professional managers to revamp current operations; and then sell the companies through a Public Offering to generate a healthy return.

In practice, the PE industry revolves around deals known as leveraged buyouts, where the PE investors put up a small amount of their own money to purchase a company and borrow the rest. The acquired business becomes responsible for repaying the debt, which puts an immediate strain on cash flows.

In their quest to generate cash and improve operational efficiency, PE firms often: lay off workers, and cut pay and benefits to remaining workers; they sell off owned real estate and lease back; they sell trademarks and other ‘off balance sheet assets’.

PE firms sometimes extract cash using “dividend recapitalizations” where they use the acquired company to borrow additional money which is then used to pay investors. Beyond that, they often charge the businesses they acquire millions in ‘management fees’.

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Shifting the treatment of so-called Carried Interest income from capital gains to ordinary compensation income could raise between $1.4 Billion and $18 Billion annually from income tax on a very small number of investment bankers.

Most informed Americans refer to the lower tax rate on Carried Interest as a loophole that allows already wealthy private equity, hedge fund and other investment managers to pay a lower tax rate than the majority of their employees and other American workers. Once they are fully informed, a significant majority of voters across the political spectrum support legislation that would close this loophole.

“It’s a real rich benefit for the wealthiest of Americans,” said Steve Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center. “Why should a private-equity manager be able to structure his or her compensation with low-taxed gains? That seems wrong.”

Sen. Sinema was elected to the U.S. Senate by voters in Arizona to represent their interests.  It’s hard to see how continuing this awful Carried Interest loophole is in the best interest of anyone in Arizona, other than to Sen Sinema herself because it seems to provide a rich and reliable source of political contributions to help ensure her continued reelection.

And that also seems wrong.

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