Obama is right about taxation of hedge fund partnerships

One of the most outrageous industry specific tax breaks is the preferential tax treatment of "carried interest" for hedge fund and private equity partnerships.

In a hedge fund or private equity partnership, the fund managers get paid by the limited partners (i.e. investors) in two ways: an annual fee, usually 1-2% of assets under management, and a percentage of any investment gains made by the fund, usually 20%. This 20% participation fee is known as carried interest.

For some reason, our tax code treats carried interest as if it were a capital gain, and is therefore taxed at a 15% rate and is excluded from payroll taxes. But carried interest is not really a capital gain. We are not talking about the hedge fund managers own money here, we are talking about a management fee. Yes it is a highly uncertain, contingent fee, but it is still a fee nonetheless.

Hedge fund managers claim that the preferential treatment is justified because the fee is uncertain and risky. But there are lots of occupations where the ultimate income is highly uncertain - a lawyer who works on contingency, an author or composer who gets paid via royalties, or a salesmen who works on commission - yet all of these folks pay taxes at ordinary rates.

The President has proposed that the preferential taxation of carried interest be eliminated, and I agree with him. His problem is that he may have to fight some members of his own party on this one - particularly Charles Schumer.

By the way, I only agree with the President with respect to the preferential nature of the tax rate, not with the idea that 15% is too low of a tax rate. I think all income should be taxed at a flat 15% rate, whether you work at a hedge fund or not.