Hedge Funds Earn Extraordinary Amounts of Ordinary Income

Investment funds, such as hedge funds and private equity funds, and their managers earn most of their income from profits on invested capital that is taxed at a preferential capital gains tax rate of 15%. Investment managers argue that they invest like everyone else, albeit on a grander scale and that they should not be penalized with higher taxes merely because they earn lots of money. Everyone else thinks it is outrageous that the very wealthiest among us should pay a preferential tax rate on their enormous incomes. Those investment managers should not pay higher taxes because they are wealthy, and most of their income does derive from capital gains. However, most of their income does not derive from their capital gains.

Preferential tax treatment for capital gains was enacted because of the realization that for most investors the capital they invest has already been taxed to them previously as wage or other ordinary income and because they need some additional incentive to take the risk of losing their money in investments. However, typically 90 percent or more of the equity capital invested by investment managers comes from third party investors who bear the risk of any investment losses. So why should those investment managers get preferential tax treatment for income they get that is derived from profits on another investor’s invested capital? Isn’t that income more realistically contingent fee income for a job well done? And shouldn’t that income be taxed as ordinary income?

No? Then maybe all companies should structure a portion of employee compensation as “capital gains” too. That compensation could be based on the value employees add to the value, or stock price in the case of a publicly traded company, of their companies. That income could then be taxed at preferential capital gain rates too. Critics might correctly point out that employees do not invest their own capital in such a scenario, and consequently are not eligible for capital gains treatment for any income earned. But isn’t that exactly what investment fund managers are doing?

Hedge funds and other investment funds earn an extraordinary amount of ordinary income. The proposal implicit in this commentary is less that the law should be dramatically overhauled, but more that it be slightly amended to coincide with the original intent and reasoning for the favorable tax treatment in the first place: that investors be encouraged to take investment risk.