Next week the Senate will likely pass a massive spending program called the American Jobs and Closing Tax Loopholes Act of 2010.
Since it’s now deemed unacceptable to simply tack another $112 billion onto the deficit, Congress needs to offset this spending with a bit of revenue from new sources, this time with a precedent-setting tax on the sale of certain small businesses.
With the administration already committed to raising income taxes, the estate tax, and with the gears already turning for a value-added tax, attention momentarily has turned to one group of small businesses: investment partnerships. Why this group in particular? Most likely it is due to their connections to Wall Street (they’re customers, but not banks) and the fact that some of them receive favorable tax treatment for a portion (sometimes a very small portion) of their income.
Under the bill, part of a particular type of income earned by some investment firms, known as carried interest, might be taxed at the 35 percent rate for earned income compared with the 15 percent capital-gains rate they now pay. Fighting this change isn’t our purpose here. Whether carried-interest income should be taxed as ordinary income or as capital gains is a subject of legitimate debate, typical of any business taxation issue.
The practical problem for Congress is that the carried- interest tax increase is “scored” by the Joint Committee on Taxation to raise only one quarter of the $19 billion or so Congress hopes to raise from these businesses. That is just not enough for their spending desires.
The remaining amount supposedly would come from a so-called enterprise-value tax, a new taxation plan whereby owners of investment partnerships that have ever earned as little as $1 of carried-interest income would become subject to ordinary income tax rather than the capital-gains tax rate on the future sale of any portion of their business. This would be a more than doubling of the tax on their long-term value creation.
Note this is not a tax on carried-interest income; but even generating $1 of carried-interest income causes the enterprise tax to kick in.
It’s a pure tax on business value. This would establish a tax for owners of investment-management firms that is different from all other U.S. businesses, which now pay tax when they are sold at the capital-gains rate. While this tax regime would apply to investment partnerships today, this sets a dangerous precedent for all businesses that might be subject to future political disfavor or have value that can be turned into government revenue.
Important to Some
The favorable treatment of carried interest-income is indeed economically important to some investment managers, including many private-equity and venture-capital fund managers. But carried-interest income is inconsequential to many others, including institutional money managers. Yet these firms would suddenly be subject to the new business value tax.
The new tax would also capture a wide range of family and other closely held businesses, often conducted in partnership form. It forces the enterprise-value tax on all of the above such that business owners who have derived trivial benefit from carried-interest income may see the tax more than double on the sale of the business they have devoted their working lives to building, while tax rates remain the same for every other type of business in America.
At best, this is a retroactive tax that will discourage investment in an important industry. At worst, it is a job- creation program for global competitors in an industry historically dominated by U.S. firms. For investment managers who have never substantially benefited from carried interest, it is simply blatant expropriation from a class currently out of political favor.
Once passed, Congress will see how easy it is to play divide and conquer, singling out small businesses one at a time for special tax treatment. The need for tax revenue is only growing and should the enterprise-value tax pass, no small business ought to feel safe.
This legislation may well prove to be the stalking horse for an effort to eliminate capital gains eligibility for the sale of all businesses. If this tax remains applicable to only one business type it’s utterly unfair and indefensible. If it is broadened to apply to more or all small businesses down the road, it will destroy jobs and hobble small-business creation.
(Clifford S. Asness is the managing and founding principal of AQR Capital Management LLC. Michael Mendelson is a principal and Brendan R. Kalb is co-general counsel at AQR. The opinions expressed are their own.)
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