Capital Gains vs Ordinary Income: How To Convert Wage Income – Video
John Hyre: Carried interest. You guys are probably familiar with this. This is a very common technique here. This hotbed of entrepreneurialism and startups. Carried interests are very common in startups.
What is that? This is what Romney did. Possibly inside of his IRA, clearly outside of his IRA. How do you convert wage income into capital gains? Because wage is on a high bracket or attached to 40% of your income tax purposes thrown on other 4% for Social Security/Obamacare tax, so 44% bracket. If I could get it knocked down to capital gains rates it’s somewhere between 15% to 20%, if it’s long-term cap gains, but normally cap gains and services don’t go together. There’s an exception.
If you are a partner in NLOC Limited Partnership, any of these that are treated as partnerships. Almost always NLOC these days, but sometimes in a Limited Partnership or Limited Liability Partnership. What happens? Instead of being paid of W-2, you’re paid a percentage of the profit.
That’s why, in tax lingo, we call it carried interest or profits interest. You have to draft the operating agreement in a very specific manner. It’s good that there’s a class A and a class B. Class A is the money guy, he puts on the capital. Class B is the profits, the SWAT equity guy. It has to make very clear to class B, that class B has zero entitlement to his capital that no way can class B get capital. They’re only entitled to what? A percentage of the growth, a percentage of the profits.
Now, here’s the other key. The underlying assets have to generate long-term capital gains because you’re paid in assets. Here’s what Romney did. Romney Rehab Corporations. Owning stock in a corporation, that’s a capital asset. If you own it for more than a year, it’s long-term capital gains tax was 15%, now it’s 15% to 20% depending on your bracket. Thank you, Obama.
If I buy corporate stock, I rehab the company and I wait at least a year and I’m paid in a percentage of that profit, I’m paid a percentage of what? Long-term capital gains. The underlying asset that is being sold ultimately that generates the profit in the partnership, that underlying asset has to produce capital gains.
For example, let’s say instead of rehabbing corporations, we do a SWAT Equity deal. Jerry and I, he puts in the money, I put it in the SWAT Equity. Let’s just say I get 30% of the profit. What’s the problem? Let’s say we do a hundred rehabs of single-family houses. That clearly makes you what’s called a dealer which means, the sale is ordinary income with self-employment taxes.
Just like W-2 wages, it is the nature of that asset. It is the nature of houses that I repeatedly flipped that they produce ordinary income. It is the nature of stock in a corporation on the other hand that it produces long-term capital gains. You have got to be paid on the currency of whatever it is you’re selling, and that currency itself has to produce long-term capital gains.
Rentals are somewhere in between. Let’s say he and I buy a hundred rentals. He puts in the money, I’m the SWAT Equity guy, I get 30% of everything. The rental income itself pays normal income tax but no Social Security tax. Then when we sell the rental, it’s mostly long-term capital gains except to the extent we took depreciation, the bracket goes up 10 points to 25% also known as recapture. A rental would be mixed.
Here your three examples, I get in the business of buying and selling corporations after we’ll rehab them, we hold the stock for at least a year. That’s always long-term capital gains. If I’m being compensated in those long-term capital gains, I get a cut of that profit stream, I have arbitrage in a major way. I’m paying long-term cap gains instead of salary, plus ordinary income plus the Social Security interest.
If we go buy flippy houses, the losses, those are treated just like W-2 income, there’s no benefit. I might as well just get a salary from them. There’s no benefit to partnering in that way, tax-wise.
Then rentals are in between. If we’re going for appreciation on the rentals and all they do is produce capital gains, I’m in luck. If we get a bunch of cashflow, the cashflow’s taxed a little differently. What’s a carried interest? I’m a profits partner and the taxation on my profits depends on the underlying asset. This is very common out here with startups. Very, very common that you get the labor, the talent. They get paid a percentage of the profits interest, has to be very carefully drafted. It’s very powerful.
Now, Obama gave an executive order which he is not supposed to be able to do with Treasury regulations and that’s probably going to get challenged. Treasury regulations in order to change them, there’s something called the Administrative Procedures Act. You’re supposed to go through a notice period. They have issued some Treasury regulations that purportedly go against these profits interests. The problem is the way it was done.
In other words, King Obama said, “I don’t need no stinking Congress. This ain’t no Republic. Here’s what you’re going to do.” Right? That is probably going to be challenged probably successfully. In other words, I still think this structure is going to survive because the Democrats are very much against it. They think Romney should pay full 44%. Questions on profits interests.
Participant: In essence, I’m hearing the underlining studies to hold something for a year and a day?
John: If that the something is a capital asset.
Participant: Define the asset.
John: Right. Right. Once you define the asset as a capital asset as opposed to inventory you hold it for a year and a day. I prefer again I don’t like cutting the margins that close.
Participant: A year and two days?
John: Okay. I see where you’re coming from. You’re the one that I’d probably be a little bit like, whoa, you know.
Participant: I’m a Real Estate Professional, Sir.
John: Okay. That tells me what I need to know. Let me let me translate that. Let me translate real estate professional. Cowboy. Other questions on carried interests?
Participant: How would someone restructure what they’re doing to have carried interest?
John: How would someone restructure what they’re doing to have a carried interest? Now, I have to ask and this is, of course, hypothetical because you would never want to tell us your personal details. Hypothetically, what are we talking about because here the facts matter? What are we restructuring?
Participant: Let’s say I’m an accountant.
John: An accountant, hypothetically.
John: The problem with that is unless you’re going to sell the firm the only way this works because accounting is a services business. If we have a partnership to provide services how are services taxed? Just like W-2 income. Your problem is the underlying asset itself is not taxed at long-term cap gains rates. Unless what?
Participant: Unless you’re partnering.
John: Yes. Unless the ultimate object is to sell the company at some point and you want to be compensated on capital gains when you actually sell the partnership or in the odd case where it’s a corporation which you wouldn’t normally do for services but I’ve seen it done hypothetically.