Wall Street managers far outstrip public company CEO’s in executive compensation – thanks to tax loopholes just for their benefit. The special series based on the book "How To Make A Million Dollars an Hour" continues.
By Les Leopold
Long before Stephen Schwarzman became a wealthy private-equity mogul, he was a Yale student—and a member of its most prestigious secret society, Skull and Bones.
In its spooky windowless mausoleum sealed with a vault-like door, Schwarzman congregated with the Yale student elite, including the progeny of presidents and potentates. Schwarzman was tapped for the secret society by an august group of upperclassmen that included George W. Bush.
If you’re not a member, and you say the words “Skull and Bones” in the presence of Schwarzman (or any other member), he’s supposed to walk out of the room. In the secret argot of Skull and Bones, all outsiders are “Rians” — short for “barbarians” — and you have no business uttering the sacred name of this elite society.
Conspicuous Consumption Shines Light on Hedge Fund Pay
Schwarzman made his fortune as cofounder (with Peter Peterson) of the Blackstone Group, a private equity fund that buys undervalued companies, restructures them, and then sells them again — at a huge profit — as public companies (think Mitt Romney and Bain Capital). Over time, the fund evolved into an all-purpose firm that combined mergers and acquisitions, hedge-fund activities, real estate, and leveraged buy-outs.
In 2007, at the peak of the housing bubble and of Schwarzman’s fame and fortune, he threw himself an over-the-top 60th birthday party. It was so big, he had to rent the Armory on Park Avenue to accommodate his admirers. He also rented Rod Stewart for a cool million to croon for his guests. The whole shebang reportedly cost $5 million, but for the billionaire it was chump change.
The sheer obnoxiousness of his excess put Schwarzman into the limelight, which he apparently enjoyed. Yet, the light blazed even brighter a few months later, when Schwarzman turned his prosperous private equity firm into a publicly traded company. Blackstone’s initial public offering (IPO) put about $4 billion into Schwarzman and his partners’ pockets. (To his credit, a year later he made a well-publicized tax-deductible donation of $100 million to the New York Public Library.)
Favorable Tax Rate For Hedge Fund Managers
But pride goeth before a fall—or, at least, we hope it does.
In pitching the IPO, Schwarzman bragged openly about a wonderful tax feature that really sweetened the deal: Blackstone paid only 15 percent in taxes on its profits, compared to 35 percent for a normal corporation.
Oops. In the process, Schwarzman inadvertently alerted Washington politicians and the public that the richest of the rich were profiting mightily from this enormous tax loophole that showered money on financial partnerships but not on regular corporations.
When you get to be an elite financier, however, you don’t feel that you should be subject to the same income tax rates as all of the little “Rians” who labor far below. You’ve earned the right to use the “carried interest” loophole that classifies almost all of your income as capital gains. Your well-compensated chauffeurs, pilots, and personal assistants might be paying at the 35 percent rate (the top tax bracket at the time. Now it's 39 percent)—but why should you?
If you have to pay at all, then 15 percent is about all Schwarzman can stomach. (Now 20 percent)
Paper on Taxing Partnership Profits Rocks Establishment
As Rod Stewart gently rocked Schwarzman’s birthday guests, Victor Fleischer, an unknown, untenured law professor at the University of Colorado, was bopping away on his keyboard, writing a wonky piece on the virtues of taxing private-equity and hedge-fund companies at something beyond 15 percent. His obscure paper, Two and Twenty: Taxing Partnership Profits in Private Equity Funds (later published in the NYU Law Review), turned him into the rock star of hedge-fund taxation.
The paper also happened to catch the eye of congressional staffers who were desperately searching for revenue sources that could substitute for the Alternative Minimum Tax. (The AMT, which had begun to hit middle-income earners, was political poison.)
Fleischer’s unassuming article crushed all the justifications for Schwarzman’s enormous loophole. Like the little boy who saw through the emperor’s new clothes, Fleischer wasn’t afraid to say so.
Senate Finance Committee Takes Up Tax Loophole
Having failed to secure an interview with Rod Stewart, I gave Professor Fleischer a try and he agreed. He joined me over a phone call in October 2011, from his law school office at the University of Colorado, where he now has a tenured position.
It all started so innocently, he told me. Back in 2007, he posted a draft of his tax article on TaxProf, a website that caters to tax professors. “It ’s common practice to seek out comments on your draft before you finalize and submit it to a law journal,” Fleischer said.
He had no idea that staffers on the Senate Finance Committee patrol that website to keep up with what academia is saying about taxes. They spotted Fleischer ’s piece and asked him to share his ideas at a closed-door session of the committee.
Practically overnight, Fleischer became a hot commodity.
He was all over TV, especially the financial shows, and was interviewed in the New York Times. Not only did Fleischer give good, clear, blunt answers, but his boyishly handsome face looked good on TV.
He was now the lodestar for an enormous tax fight that still rages on today. Or, as the young, star-struck professor put it, “The most pleasant surprise was that I’m not writing for an audience of 12.”
Wall Street Managers’ Pay Exceeds Main Street Managers’ Pay
Fleischer knows that he has Schwarzman to thank for his newfound fame. “Schwarzman has a knack for making himself look like an ass,” said Fleischer. Case in point: As reported on BusinessInsider.com, Schwarzman used these ill-chosen words to describe the Obama administration’s efforts in 2010 to raise taxes on private equity firms and the wealthy:
“It’s a war... It ’s like when Hitler invaded Poland in 1939.”
Was Schwarzman implying that if you wanted to take away his precious tax loophole, you were a Nazi?
Fleischer fired the opening volley in the campaign to close Schwarzman’s beloved loophole. In his article, Fleischer zeroed in on the subject of outsize hedge-fund compensation:
Ironically, while the public and the media have focused on the “excessive” pay of public company CEOs, the evidence suggests that they are missing out on the real story. In 2004, almost nine times as many Wall Street managers earned over $100 million than did public company CEOs; many of these top earners on Wall Street are fund managers.
Then he added the kicker that ignited the debate:
And fund managers pay tax on much of that income at a 15 percent rate, while the much-maligned public company CEOs pay tax at a 35 percent rate on most of their income.
What’s more, the professor argued, he could find no reasonable justification for giving fund managers such an enormous tax break.
Hedge Fund Managers React
Schwarzman and company did not take kindly to Professor Fleisch’s paper. Fleischer noted:
"I received a lot of hate mail, dozens of them. People mailed me out of the blue. They called me a socialist. They compared me to Stalin. You can’t blame them. If the loophole were closed, we’d be more than doubling their tax bill."
Yet, Fleischer had serious admirers as well, including in Congress. Senator Carl Levin and others used Fleischer’s information and arguments to fashion a bill that would greatly tighten this tax loophole. Versions of that bill passed the House several times but the Senate bill hasn’t seen the light of day. President Obama has also repeatedly called for closing this loophole—including as a way to help finance the job stimulus bill he proposed in September 2011 (and again in his 2014 proposed budget).
The loophole’s fate remains unclear.
Nevertheless, because Congress rarely sides against Wall Street, expect the carried-interest loophole to still be there when you make your first billion.
Step 9: Bet on the Race After You Know Who Wins
Step 8: Have the Right People Whispering in Your Ear
Step 7: Don’t Say Anything Remotely Truthful
Step 6: Rig Your Bets
Step 5: Betting Is For Chumps
Step 4: Use Other People's Money
Step 3: Rip off Entire Countries Because That's Where The Money Is
Step 2: Take, Don't Make
Step 1: How To Make A Million Dollars An Hour In Twelve Easy Steps