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R. Klein, EA
R. Klein, EA, Enrolled Agent
Category: Tax
Satisfied Customers: 2882
Experience:  Over 20 Years experience
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Customer Question

Hi!

I am an investment manager and manage a few separately managed accounts. (I am the authorized trader on accounts that my clients keep with a retail broker: TD Ameritrade). My clients pay me a portion of their profits (and no management fee). Last year, there were profits on their accounts and they allocated part of it to me. They paid me in cash, by transfering money from their account to one that belongs to me.

Can I claim this income as capital gains, as is customary in the investment management business, or is this ordinary income?

Thank you!
Submitted: 2 years ago.
Category: Tax
Expert:  R. Klein, EA replied 2 years ago.

Randalltax :

This would NOT be capital gains income because it is ordinary income as compensation to you.

Randalltax :

You cannot transfer the nature of the funds from one person to another. In other words, a capital gain for the customer paying you money does NOT make it a capital gain for you.

Randalltax :

Capital gain requires YOU to invest YOUR money and, for the purposes of long term treatment, be considered invested for at least a year and a day (but you knew that part).

Randalltax :

Also, this would *not* be customary to treat this as a capital gain to you in any respect.

Randalltax :

On top of this ordinary/capital gain argument, cash is never a "capital gain" even though cash IS capital!

Customer : Thank you for your reply Randal!
Customer : a follow-up then:
Customer : I know that some performance allocation income of investor managers is considered capital gain, and thus the debate around it. (Since it is indeed a compensation for a service performed.) Under what circumstances then can an investment manager claim this income as a capital gain?
Customer : I am referring, of course, to the debate around compensation of Private Equity managers and Hedge Fund managers and the appropriate tax rate for it.
Randalltax :

The only time that you can have a capital gain is if you shared in the account as an owner and the shares converted to your full ownership.

Randalltax :

PE managers often get comped in shares of stock instead of a cash payment

Randalltax :

At the time the stock is "earned" it is full taxable as ordinary income and this becomes the basis for the stock when sold later. THEN after holding the stock, the PE manager sells his personal holdings, NOW you have a cap gain

Randalltax :

Imaging you are representing company ABCD which is about to have a liquidity event. The company pays you 1000 shares worth $5 each. You then have $5000 in ordinary income.

Randalltax :

When the liquidity event occurs, you sell the shares for $10 each, and realize a $5K capital gain.

Randalltax :

Of course, capital gains for investments held short-term are taxed at ordinary rates anyway, so the holding has to be long-term for any real benefit.

Customer : But, if upon receipt of the shares (worth $5 each), they are taxed as ordinary income (for total taxable amount of $5000), then what is the controversy? Suppose that you are a fund manager sharing an account with just one client. He deposits $100. At yearend, it is worth $120, after appreciation of market value. Your share of the gains, as the manager, let's assume, is 20%. So $4 is your share. Let's imagine that you are paid in securities (as you describe). I understand you to be saying that, still, these $4 will be considered ordinary income. And only any subsequent appreciation in price will be a capital gain. So -- why the controversy then? Or, in other words, what would be an alternative method of taxation on fund managers' and private equity managers' compensation?
Customer : I understand that fund managers' compensation is a highly debated and controversial issue right now because they are allegedly currently taxed on their performance allocation compensation not as ordinary income, but as capital gains.
Expert:  R. Klein, EA replied 2 years ago.

I'm not here to debate whether the comp is fair and equitable or not; just the taxation of the compensation.

 

However, being a former licensed broker, I don't even like the idea of sharing an account with a client. Too much legal exposure.

 

Compensation, when earned, cannot be capital in nature. It just isn't. There are too many fools out there in the financial businesses that don't know what they are talking about when they suggest that their compensation is not ordinary income. It always is. Most of these guys (maybe you as well, I don't know) are salespeople, not tax experts. They say things that may not be true when put under the spotlight.

 

In order to have a capital gain, you have to own a capital asset. Compensation is NOT an asset; it is income.

 

However, as I said earlier, you can get paid in things that are not cash, including capital assets. But the receipt of that asset is ORDINARY income. Always.

 

 

Customer: replied 2 years ago.
Randal, I respect your opinion, but believe that you are wrong in your assertion that compensation of a fund manager is always taxed as ordinary income. Please refer to this wikipedia article on carried interest: http://en.wikipedia.org/wiki/Carried_interest
Customer: replied 2 years ago.
Relist: Inaccurate answer.
Expert:  R. Klein, EA replied 2 years ago.

Sorry, but that article reinforces my points.

 

Per your citation

"The reason for this treatment is that a fund manager would make a substantial commitment of his own capital into the fund and carried interest would represent a portion of the manager's return on that investment. While hedge funds typically trade their investments actively, private equity firms tend to hold their investments for many years"

 

It requires that you have a stake.

 

When you are paid in cash or cash fee, that is not a stake coming back to you.

 

 

Customer: replied 2 years ago.
That is true. But the capital gains treatment is not exclusive to the gains on the manager's own investment. Rather, it applies to both his own investment and the performance allocation that he receives from his investors.

This is contrary to what you said to me when you said "Compensation, when earned, cannot be capital in nature."
Expert:  R. Klein, EA replied 2 years ago.

Not really contrary.

 

As you read, Congress has tried on many occasions (and still to this day) to try to make the wording clear that this is a completely true statement.

 

As with many things in life, the Golden Rule applies. Those with the Gold try to make the Rules.

 

What you really have to watch out for is if Congress passes a law then makes it retroactive! They have done that in the past!

 

 

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