President Obama Could End the Hedge Fund Tax Break. Why Doesn’t He?

Commentary about business and finance.
June 2 2014 4:00 PM

Why Doesn’t Obama End the Hedge Fund Tax Break?

All he has to do is ask.

Barack Obama.
President Barack Obama speaks to the media at the White House on May 30, 2014, in Washington.

Photo by Alex Wong/Getty Images

The Obama administration could disable one of the most powerful sources of wealth and income inequality in our country. Yet no one ever mentions it as a possibility. Don’t they know?

There have always been disparities in income, of course, but the gap now isn’t so much between the rich and poor as between the super-rich and everyone else. There’s no more dramatic example of this than the astronomical income of hedge fund managers and traders, and the special tax break that allows them to pocket so much of that income. The most remarkable aspect of this fabulous new wealth is that much of it is simply a gift from the government—a gift that could be eliminated by the stroke of a pen.

A quick refresher on how the tax break works: An executive salary is taxed at 39 percent, the highest rate for earned income. But the income of a hedge fund manager is taxed at only 20 percent, which is the highest long-range capital gains rate—even though the hedge fund manager is deriving income that’s as directly earned as the wages of a steelworker. He made money when he established his fund. But the rule for hedge funds is that the “realization event”—when income is realized—is not known until later, so “carried interest” turns the income into a capital gain. This is what’s known as a legal fiction, which means that it’s a great big lie.

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Warren Buffett won a lot of praise by pointing out that his secretary pays taxes at a higher rate than he does. Actually, Buffett’s 20 percent rate is not due to the hedge fund loophole, but presumably because the vast majority of his income comes from dividends or capital gains, which are taxed at the lower rate because the corporation has already paid taxes on that income when it was first earned. Unlike the directly earned income of hedge fund executives, the “same” money is being taxed twice. Buffett’s point is well-meaning, but it’s in fact more appropriate when applied to the special tax privileges enjoyed by hedge fund operators.

There is no justification for taxing hedge fund managers’ income as capital gains. So how could Congress have done such a thing? Here’s the secret: Congress didn’t do it. There are a lot of special deals that the federal legislature has snuck into law, but this isn’t one of them.

The hedge fund tax loophole wasn’t a bill that was passed into law; it was never voted on. It was part of a revenue procedure issued by the Internal Revenue Service in 1993, before there was any such thing as a hedge fund.

According to Alan Wilensky, who in 1992 and 1993 was the acting assistant secretary of the Treasury for tax policy, the revenue procedure intended to clarify the tax treatment of some real estate investments. It defined a “realization event” as when an interest in a piece of real estate was sold or exchanged; if the event happened more than year after the real estate had been acquired, then the tax would be considered on a long-term capital gain.

Later, when hedge funds started to come into being, the IRS applied the same revenue procedure to this completely different new financial device. No new ruling was issued—the old one was just assumed to cover it. This may have been understandable given the small number of hedge funds at the time, but by the end of the 1990s, hedge funds had become a wildly profitable and highly visible part of Wall Street. Robert Rubin, then Treasury secretary, could have asked for a new revenue ruling but chose not to address the new landscape.

And there still has been no hedge fund–specific ruling on this matter. That’s why hedge funds could lose their tax advantage if only the IRS issued a new ruling saying so—no act of Congress required. The IRS is part of the Department of the Treasury. The secretary of the Treasury is appointed by the president and is part of his Cabinet.

So the outrageous exemption from fair taxation could be ended right now if only President Obama would pick up the phone and order it done. He’s the one who’s been claiming that administrative remedies are just fine, despite the presence of the Congress: When Congress couldn’t move on the minimum wage bill, the president applied a new higher wage to federal contractors—and he did this administratively. The guidelines to cut carbon pollution are likewise administrative.

So: Go for it, Mr. President. With one call you could bring enormous new revenues into the Treasury each year, and, not incidentally, cut the price of Picassos in half, to say nothing of the effect on $80 million condos.

What swift action by the president will not do is impoverish hedge fund managers. Paying the same tax rates as their accountants will not clean out the hedge fund kings. The 25 highest-earning hedge fund managers and traders made a combined $24.3 billion in 2013, according to Nathan Vardi in Forbes.

There’s a 31-year-old hedge fund manager who made $119 million in 2013. And he’s almost certainly paying taxes at a lower rate than most people reading this article. It doesn’t have to stay that way.

David Lebedoff is a lawyer and writer in Minneapolis. His books include Cleaning Up: The Big Spill, From Alaska to the Gulf and The Same Man: George Orwell and Evelyn Waugh in Love and War.

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