Democrats and liberals have been arguing that the "carried interest" of hedge fund mangers should be taxed at ordinary income tax rates. This issue has been articulated as a completely indefensible "loophole" granted to these wealthy individuals for no valid reason. I believe that this issue is considerably more complicated than that analysis would suggest.
I always hold out the hope that one of the differences between liberals and conservatives is that liberals tell the truth. It may be unintentional, given the complexity of the issue, but I think that many liberals are not telling the whole truth regarding the taxation of hedge fund managers. The "carried interest" has been described as a "fee" that is able to get long-term capital gain treatment because the hedge fund managers have been granted a "loophole" in the tax code. While there is some truth to this characterization, the reality is much more complicated. This area is quite technical, but I will try to explain the rules as simply as I can and then explain why the current treatment of hedge fund manager may well be proper. I am both a liberal and a tax lawyer, so hopefully I have credibility on this issue.
Currently most hedge funds are organized as limited partnership, with the hedge fund manager serving as the general partner. Under federal tax laws, a partnership itself does not pay tax, rather the partnership's income is "allocated" to the partner who are resonsible for paying the taxes on the partnership's income. The general partner of a hedge fund partnership is "compensated" typically in two ways: (1) a management fee (typically from 1-2% of asset under management) and (2) a "carried interest" entitling the general partner to a percentage (traditionally 20%) of appreciation in the value of the partnership's assets. The management fee is ALWAYS taxable as ordinary income, so there really is no controversy regarding treatment of those payments. The "trick" is the carried interest.
The real issue that no one is really discussing is that the carried interest is not taxable on receipt. So if the investors (limited partners) put in $100 million, and the general partner gets 20% of appreciation in the value of the partnership's investments in excess of $100 million, the general partner has no income at that time (because at that time the entire value of the partnership is only $100 million and thus there is no current value in excess of $100 million). Many people believe that this tax result is the error in taxation, but none of the current proposals being considered attempts to change this result. Of course, there is real economic value in the right to 20% of appreciation in the value of the hedge fund's assets, but current taxation of that amount would result in a very large amount of "phantom" income (i.e., income without any cash to pay the tax) to the hedge fund manager at the beginning of the hedge fund formation. So no one seems to be considering changing that rule.
The issue actually being discussed is how to tax the general partner when the hedge fund (i.e., the partnership) eventually recognizes a gain on the investment of all or some portion of the $100 million invested by the limited partners. Keep in mind, that in general, the partners of a partnership recognize income in the same character as the partnership--so if the partnership recognizes ordinary income, the partners recognize ordinary income, and if the partnership recognizes capital gain, the partners recognize capital gain (as noted above, the partnership itself does not pay tax but rather the income "passes through" to the partners who then pay the tax on their individual income tax returns). So if the hedge fund sells its assets for $110 million, the assets have appreciated by $10 million, and the partnership has $10 million of gain--$2 million of which is allocated to the hedge fund manager (i.e., the general partner). If the asset is a capital asset (such as stock) and has been held by the hedge fund for more than one year, then the $2 million is allocated to the hedge fund manager as long-term capital gain. Otherwise, this amount generally would be ordinary income (with certain special exceptions). Many hedge fund managers engage in short-term trading strategies, and so those hedge fund managers already recognize their "carried interest" income as ordinary income because the partnership's gain is not long-term capital gain. But, for those hedge fund managers who invest the limited partner's contributions in capital assets and then sell them at a gain more than one year later, the gain will be long-term capital gain.
Many people have argued that because the hedge fund manager has not put in its own capital, the "carried interest" is really the equivalent of a fee for services. Certainly there are financial advisors who take a "fee" based on a percentage of profits earned for their clients, and that amount is taxable as a fee, even where the investor recognizes long-term capital gain. So based on that analogy, the "carried interest" appears to be a fee.
But there are other possible analogies that have different tax consequences. For example, assume a person starts a business (e.g., a candy store) organized as a partnership, but the person running the business puts in no money personally. Assume that investors put in all the capital, and the "manager" get an interest in the partnership (as the general partner) based on 20% of the profits over the invested capital. Again, as discussed above, the manager does not have any income on receipt of this 20% interest in profits (essentially identical to the "carried interest" of the hedge fund manager). Assume the manager works the candy store for a few years and then sells the store at a profit. The investors get 100% of their money back plus 80% of the profit above their investment and the manager gets 20% of the profits. In general, this amount is taxable to the candy store manager as long-term capital gain (with some limited exceptions). This candy store manager is just like the hedge fund manager in that the candy store manager put in no capital and receives a share of profits based solely on the manager's personal efforts. Nevertheless, no one is suggesting changing the rule to tax this situation as ordinary income to the candy store manager rather than long-term capital gain. Nevertheless, arguably, this fact pattern is just as analogous as the financial advisor analogy discussed above.
In my opinion, what this analysis really supports is my basic view that ordinary income and long-term capital gain should be taxed at the same rate (although high taxation of capital gain can lead to economic distortion by locking in "bad" investments because the tax hit discourages trading into better investments). But as long as we are going to have a reduced tax rate for long-term capital gain, focusing on a particular group of people (e.g., hedge fund managers) merely because they often earn a great deal of money does not seem to be a valid reason to support taxing them at a higher rate than we tax other people in analogous situations.