WASHINGTON — If you landscape gardens, remodel bathrooms or sell real estate, you're probably taxed at the usual income tax rates — up to 35 percent of your income. But if you're a private-equity fund manager, you might take home $1 billion or more in fees for handling investments for the wealthy, and you enjoy a low tax rate of 15 percent.
If that doesn't strike you as fair, you're in good company. Democrats in Congress are zeroing in on this discrepancy and promising to fix it.
Influential private-equity funds and some hedge funds — both of which invest billions of dollars on behalf of the very wealthy — aren't going down without a fight, however. They're lobbying to keep the status quo, they have friends in both political parties and they're bundling donations to presidential candidates in both parties as well.
Private equity funds raise money from the ultra-wealthy and big institutions such as pension funds, insurance companies and charitable endowments. They invest it in taking over publicly held companies, restructuring them and selling them for profit. Hedge funds raise money from the same sources but have a wider array of investments.
Democrats are eyeing these fund managers — who have more than $2.46 trillion in assets under their stewardship — as tax targets because many lawmakers think they're getting an unfair break.
Self-employed people such as gardeners or real estate agents are taxed as "sole proprietors" and "independent contractors." If they have taxable income above $31,850, they pay a rate of 25 percent; above $77,100 they pay a rate of 28 percent; above $160,850 they pay a rate of 33 percent; above $349,700 they'd pay a rate of 35 percent.
Not so for managers of private equity funds, who are subject to a different tax structure. They pay only a 15 percent rate. And these funds are generally limited partnerships and thus not subject to corporate taxes as high as 39 percent of income. Here's how they justify it: Private-equity fund managers generally don't take big stakes in their own funds, often owning 2 percent of the assets or less. Instead, their contracts usually demand a 20 percent share of profits, a practice known in tax law as "carried interest."
The theory is that fund managers have more to lose if a fund isn't profitable, and more to gain when they're profitable. Their profits are taxed as capital gains, and thus subject to the lower 15 percent tax.
"I'm a no-tax guy, but why carried interest should go at a preferred rate is beyond me," said Jeremy Siegel, a business professor at the University of Pennsylvania's Wharton business school. He favors legislation to strip this tax break from fund managers.
Democrats have seized the issue as part of their broader campaign to address income inequality. Over the past two decades the wealthiest 10 percent of Americans, and especially the richest 1 percent, have grown much richer much faster than everyone else.
"For several years now, it's not getting better for most people," said Rep. Barney Frank, D-Mass., the chairman of the House Financial Services Committee and a co-sponsor of the bill to close the tax break for private-equity fund managers.
The question before Congress is whether work performed by these fund managers is somehow different from that of the managers of mutual funds or financial planners, whose pay is taxed as income instead of as capital gains.
"If people are getting rich because they have economically valuable skills, then, while we may applaud what they are doing, we want them to pay tax at the top marginal rate," said Daniel Shaviro, a tax-law expert at New York University.
Shaviro said that if equity- and hedge-fund managers brought investors returns no higher than ordinary stock-index mutual funds, they wouldn't be able to command such high fees. But their ability to achieve much higher returns, he said, underscores the value of their labor and points to why these earnings should be taxed as income, not capital gains.
“Almost all other performance-based compensation is effectively taxed as labor income and treated as such in the tax code. Contingency fees, for example, on movie revenue for actors are taxed as ordinary income, as are performance bonuses, most stock options and restricted stock grants,” Peter Orszag, the director of the Congressional Budget Office, told the Senate Finance Committee on Wednesday.
The Private Equity Council, which lobbies for 11 of the largest funds, boasts that a $1,000 investment in 1980 would have returned $3.8 million to the investor by 2005. Over those 25 years, private equity funds returned 39.1 percent annually, on average, to their investors, versus 12.3 percent average returns from the S&P 500 stock index.
What the council doesn't say, and why fairness is a big part of the debate, is that very few of these funds would have allowed investors with only $1,000 to buy in. These funds are open mainly to the very rich; many require a minimum investment of $100,000.
Top House Democrats propose taxing at a 15 percent rate only the profits that private-equity fund managers derive from assets they own — their "skin in the game." Remaining profits would be subject to income tax.
Former Treasury Secretary Robert Rubin, a onetime co-chairman of Goldman Sachs & Co., supports this move. But the current treasury secretary, Henry Paulson, also a former chairman of Goldman Sachs, opposes it.
"We don't really want to single out a specific industry," said Andrew DeSouza, a Paulson spokesman. "We especially want to make sure there are no unintended consequences in making changes to the tax code."
The Private Equity Council contends that the retirement assets of millions of Americans are at stake, as some of the biggest corporate and public pension plans have large stakes in private equity funds.
The states of Oregon and Washington, for example, respectively have 15 and 14 percent of state pension assets invested in private equity funds. The pension funds of General Electric, Hewlett Packard and Boeing each have about 7 percent of their assets invested in private equity funds.
"The idea of changing the economic model ... could substantially hurt those folks," said Robert Stewart, a spokesman for the council. His group estimates that the top 20 public pension plans have $111 billion invested in private equity funds, while corporate pension plans have $44 billion invested in them.
Some tax experts say the council's warning is an empty threat, because the funds aren't going to stop investing if their managers lose their tax break.
"Anytime you tax two similar activities in different ways, people are going to figure out ways to arrange to pay the lower tax," said Len Burman, the director of the Tax Policy Center, a joint effort between the centrist Urban Institute and the liberal Brookings Institution. "These are pretty simple tax-shelter arrangements."