Why Hedge Funds Should Fear a Hillary Clinton Presidency

Hillary Clinton has put Wall Street on notice.

Hedge funds, private equity, and big business have a fight coming, and Clinton just threw the first punch.

Clinton's laundry list of problems with hedge funds and other Wall Street elitesOn the campaign trail in Iowa earlier this month, Clinton lambasted Wall Street again and again. She said, "There's something wrong when CEOs make 300 times more than the American worker," and "I think it's fair to say that if you look across the country, the deck is stacked in favor of those already at the top."

And then she really started dropping bombs.

"There's something wrong when hedge fund managers pay less in taxes than nurses, or the truckers I saw on I-80," she said, referencing the interstate between her home in New York and Iowa.

Want to get the attention of the hedge fund industry? Talk about raising their taxes.

One word that'll make any hedge fund manager squirmAt issue is how ordinary income -- typically wages received working at a standard 9-to-5 job -- are taxed at a higher rate than investment gains, called "capital gains" in accounting parlance. Capital gains are the form of income hedge funds report most often.

In some cases, ordinary income can be taxed at nearly twice the rate of capital gains. This difference is how Warren Buffett is able to explain that his secretary pays a higher tax rate than he does.

Most economists and pols consider raising the capital gains tax much higher a bad idea, but that doesn't mean Clinton wouldn't attempt to reclassify hedge fund income from investment gains to ordinary income. That approach is at least plausible and could nearly double the tax rate hedge funds pay.

Huge dollars are at stakeConsider a hedge fund that currently pays a tax rate of 20%. (Many hedge funds are structured as partnerships, meaning the business's tax liability is passed through to the individual partners. We'll ignore that here just for simplification -- it's more or less six of one, half a dozen of the other at the end of the day.) Taxes are calculated based on the company's net income. So if our hypothetical firm earned $100 million profit before taxes, today it would pay $20 million in taxes for an after-tax return of $80 million.

If Clinton were to successfully change the tax treatment of hedge fund profits from capital gains to ordinary income, our firm could now be taxed at upwards of 39.6%!

The math works out that the $80 million profit under the current system would be cut by 24.5% to $60.4 million. That's still a huge sum by most any standard, but at the largest hedge funds it could cut billions from annual profits.

Should everyday investors be concerned?You may be asking how these potential changes could impact your own tax returns. Most likely, they won't, but it's still a reasonable concern.

First, Clinton makes it abundantly clear that she is targeting the ultra wealthy and the upper echelon of the financial world. So unless you're a hedge fund manager yourself, you can sleep easy. Reforms would most likely seek to close loopholes in the current tax structure that only sophisticated hedge funds and private equity firms take advantage of, like the treatment of carried interest in these complicated corporate structures.

Second, the structure of the capital gains tax is one of the most powerful tools the government has to encourage the populous to save and invest. If you buy and hold your investments, you don't pay a dime in taxes until you sell. And then, if you hold the investment for at least one year, the tax you pay on any gains is just 20%, well below the ordinary income rates discussed above.

And to be clear, encouraging American's to save and invest is a priority for politicians on both sides of the aisle.

So while capital gains are a very important issue for everyday investors like you and me, the reality is that these reforms are targeting the biggest players with the most advantages. Your capital gains will most likely stay out of the cross hairs.

There is still a long campaign ahead for Clinton and all the other 2016 hopefuls, and even after the votes are counted there will certainly be many tough political fights to enact any significant tax reform.

But for hedge funds today, it seems safe to assume that Hillary Clinton's early posturing in the race has probably gotten their attention.

The article Why Hedge Funds Should Fear a Hillary Clinton Presidency originally appeared on Fool.com.

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