First, the “Big Four” accounting firms weighed in on the Tax Gap. Now, the American Institute of Certified Public Accountants, the trade association for the accounting community, has added its input.
While only 1.3 percent of accountants believe that honest errors are the main source of the Tax Gap — no surprise there, since these are the same folks who prepare our taxes — nearly half suggested the small business community was responsible for the underpayment of the remainder of taxes owed.
The survey is on their website, but just one more reason for the small business community, and S corporations in particular, to be concerned.
Should S Corps Worry about Taxing Hedge Funds?
As you may have heard, both the House and the Senate are taking a hard look at how hedge funds are taxed. The concern is that wealthy hedge fund managers are subject to lower tax rates than most middle class families.
Hedge funds make their money generally through a 1 to 2 percent management fee plus a 20 percent share of any trading profits. This 20 percent “carried interest” is treated as a capital gain and is currently taxed at a top rate of 15 percent. Congress is considering treating carried interest as regular income, which would be taxed at rates up to 35 percent.
How much money is at stake?
According to the Managed Funds Association, there are approximately 8,000 hedge funds with total assets of about $1.2 trillion dollars. If the funds make an average rate of return of 10 percent, then the carried interest earned by hedge fund managers would be about $25 billion a year (20 percent of $120 billion in earnings). Raising the tax rate from 15 to 35 percent on $25 billion would raise $5 billion a year.
Even in Washington, that’s a lot of money.
Should S corporations care? As far as we know, there are no S corporation hedge funds. At its very core, however, the issue before Congress touches on the very difficult question of separating capital income from labor income. Here’s an example:
Two investors partner with a famous chef to start a restaurant. The investors put up money, while the chef puts up his name and reputation. Each receives one-third ownership in the venture. If they sell the restaurant for a profit ten years later, the gain from the sale is treated as a capital gain for federal tax purposes — even the chef’s share.
Although the chef did not put up any money, his investment is considered to be the reputation he has as a chef. Moreover, the gain on the sale of the restaurant was not guaranteed. If the venture failed, the investors would have lost their money, and the chef would have lost his reputation.
Carried interest received by hedge funds has similar qualities. The hedge fund managers do not put up any money of their own, but they are risking their reputations and proven talents. Moreover, they earn carried interest only if the fund makes a profit.
Obviously, there are significant differences between the tax treatment of carried interest and the treatment of small business sales, including the politics of the issue. The Joint Committee on Taxation just issued a comprehensive report highlighting these issues. But the broad theory behind the tax treatment of the two transactions is similar enough that S corporations and other small businesses should pay attention. As with the tax treatment of hedge funds, there’s a lot of money at stake.