This article first appeared in the September 30, 2015 edition of Tax Notes Today.
For months, billionaire real estate developer and Republican presidential candidate Donald Trump has been likening hedge fund managers to bandits because of how they make out under the tax code.
Typical of his remarks were ones during the second Republican presidential debates held on September 16 at the Ronald Reagan Library in Simi Valley, California. Trump vowed that when his tax plan became public, "the hedge fund guys won't like me as much as they like me right now. I know them all, but they'll pay more."
In a typical arrangement for hedge funds or private equity funds, managers get most of their compensation from a 20 percent share of investment profits. But because of carried interest treatment, they pay taxes on that share at the lower capital gains rate instead of at the rate for earned income. The rest of their compensation comes from a management fee equal to 2 percent of a fund's assets, which is taxed as ordinary income.
The Congressional Budget Office has estimated that carried interest treatment would cost the government $17.4 billion over a decade.
When Trump released his plan on September 28, he proclaimed he was eliminating the preferential tax treatment of carried interest for not only hedge fund managers but others involved in "speculative partnerships." But after getting a chance to look at it, some tax policy observers said that other parts of his tax plan create options for those taxpayers to prosper more than ever, especially the section that calls for taxing all businesses large and small at no more than 15 percent, compared to the current corporate rate of 35 percent.
That means hedge fund managers could organize themselves as small businesses or a limited partnership, if they aren't already, and change their compensation so that far more of it -- or perhaps all of it -- comes from fees rather than carried interest. That way, they would pay taxes at the 15 percent rate, quite a difference from the current 23.8 percent capital gains rate for high-income filers, as well as the current 39.6 percent top rate that applies to their management fees.
"Under Trump's plan, fund managers would restructure the carry as an 'incentive fee' -- like many hedge funds use -- and qualify for the 15 percent business income tax rate. And management fees and other fees would qualify for the new lower rate as well," Victor Fleischer, a law professor at the University of San Diego, told Tax Analysts.
"Any tax lawyer worth his salt could work it out," added Steven Rosenthal, analyst at the Urban-Brookings Tax Policy Center. "As a tax lawyer, I could stretch the 'small business' exception beyond recognition."
Rosenthal also said, "That's what happened in Kansas." He referred to recent sharp state tax cuts there that have eliminated all taxes on sole proprietorships, partnerships, and limited liability corporations.
Similarly, Jay Soled, professor of tax law and accounting at the Rutgers University Business School, said many of the Trump plan details remain "quite sketchy," but added, "That being said, I think hedge fund managers [would] shoehorn themselves as part of a 'business' and attempt to qualify for the 15 percent rate."
The Trump campaign did not respond to a request for comment.
Moreover, Soled said Trump is effectively creating a new hedge fund "loophole" through the small business option. He then added: "Whatever Congress does to close this loophole, however, will have little meaningful effect on keeping Trump's tax proposal revenue neutral [or] indeed, keeping the government in the black. It's truly a grain or two of sand on a vast beach."
Rosenthal, too, said the potential revenue loss "would be massive." While there are no firm estimates yet on the cost of Trump's overall plan, several observers have already said it would likely cost more than the one offered by former Florida Gov. Jeb Bush, another GOP White House candidate, whose plan the Tax Foundation scored at a cost of $3.6 trillion over 10 years, and $1.6 trillion under dynamic scoring.
Said Rosenthal, "Trump's plan won't work."