Private-equity executives, who spent millions of dollars successfully fighting efforts to raise taxes on their investment profits, may not escape a new 3.8 percent levy in President Barack Obama’s health-care law.
The overhaul enacted two years ago includes a tax on unearned income to help pay for the expansion of insurance coverage. It’s set to start in 2013 and will apply to capital gains -- such as private-equity managers’ profits on leveraged buyouts -- as well as interest, dividends, annuities, royalties and rents for married couples who make more than $250,000 and individuals who earn at least $200,000.
“It’s going to make a huge difference for people with capital gains and any type of investment income,” said Jere Doyle, senior vice president at BNY Mellon Wealth Management, a unit of New York-based Bank of New York Mellon Corp.
The impact will be even greater if tax cuts enacted during the presidency of George W. Bush expire as scheduled at the end of this year. Unless Congress acts, the top rate on long-term capital gains and dividends, now 15 percent, would go to 20 percent and 39.6 percent. For high earners above the threshold, the health-care tax would bring the levy on dividends to as much as 43.4 percent.
The Supreme Court heard arguments last week on the constitutionality of parts of the health care law, and a ruling expected by the end of June could determine whether the tax takes effect.
The share of profits private-equity managers receive from investments is known as carried interest. It is often taxed as capital gains, which carry a lower rate than ordinary income and fall under the new Medicare levy, said Elizabeth Kessenides, a tax attorney in New York City who represents people in financial services including private-equity and hedge-fund managers.
“Investors in these funds and also the managers in these funds are likely to incur this tax,” said Kessenides. “It looks like they’ll be caught.”
The largest U.S. private-equity funds and venture capital firms have relied on a five-year, multimillion-dollar lobbying campaign to protect the carried interest tax break that has benefited fund managers including Republican presidential candidate Mitt Romney, whose effective tax rate was below 14 percent in 2010, according to returns released by his campaign.
The private-equity industry has argued that carried interest should be taxed as investment income rather than wages because it encourages entrepreneurial risk-taking.
Impact on Investments
“Raising taxes on capital gains income could adversely impact future investment in all sectors of the economy,” Steve Judge, president and chief executive officer of Private Equity Growth Capital Council, said in an e-mail. “The new surtax would apply to all long-term capital gains investments, including carried interest.” The council is a trade group in Washington that represents private-equity firms.
The new Medicare tax also captures gains made by businesses that trade financial instruments or commodities, according to the legislation. That means it may apply to hedge funds and others trading derivatives, said Patrick Cox, tax chair and partner at the law firm Brown Rudnick LLP in New York.
The government may release its regulations implementing the tax in the next few months, Lisa Zarlenga, tax legislative counsel at the Treasury Department, said at a panel discussion March 23. Details also are needed on what deductions or offsets may be available, Cox said.
In addition to the tax on investment income, the health-care law applies a 0.9 percentage point increase starting in 2013 to the Medicare payroll tax on wages in excess of $200,000 for individuals or $250,000 for joint filers.
An estimated 4.1 million households, or 2.4 percent, would be affected by one or both of the new health-care taxes, data released by the Tax Policy Center in Washington on March 28 show. The thresholds aren’t indexed for inflation so the percentage of people subject to the levies almost doubles by 2022, said Jim Nunns, a senior fellow at the nonpartisan group.
Combined, the two additional taxes mean a couple earning $400,000 in wages next year with $650 in interest income, $7,150 in dividends and $7,150 in long-term and short-term gains on investments would pay an extra $1,914 in federal taxes, said Christopher Judge, senior manager in financial services at Ernst & Young LLP.
Total Tax Bill
The family’s total tax bill including state and federal liabilities would be about $150,700 in 2013 if they live in New York City. For California residents that figure would be about $140,400, Judge’s calculations show. Both scenarios assume that Bush-era tax cuts expire and that the family owns a home with a mortgage.
In cases where property values have risen dramatically, the tax would apply to profits from home sales. The law doesn’t change current rules that allow the first $250,000 in home-sale gains for individuals and the first $500,000 for married couples to be excluded from income and exempt from taxation.
The pending tax is spurring planners to come up with ways to lessen its impact, said Jeanne Sullivan, a director at KPMG LLP in Washington. Because the tax takes effect Jan. 1, those affected may need to start paying for it as early as April 2013, if they file estimated payments, she said.
Strategies advisers suggest include realizing capital gains in 2012, shifting assets to Roth retirement accounts and adding to municipal bond holdings where gains likely won’t be taxed. Investors in any business partnerships or S-Corporations should consider taking a more active role.
“Anyone who has gains in their investment portfolio should consider selling and taking their profits in 2012 before this Medicare surtax comes into play,” said Allison Shipley, a principal in the private company services division of PricewaterhouseCoopers LLP. “You need to consider your transaction costs in trading but taking gains may be an effective strategy for people.”
The tax makes Roth individual retirement accounts more attractive because the income isn’t subject to tax when it’s distributed. The distributions also aren’t included in the $250,000 and $200,000 income thresholds, William Long, who heads the private wealth services team at McGuireWoods LLP in Chicago, said in an e-mail.
The tax also won’t apply to municipal bond interest, said Tim Steffen, director of financial planning at Robert W. Baird & Co. in Milwaukee, Wisconsin. “That will make munis more attractive,” he said. While municipal bonds may have lower yields than corporate issues, the securities generally are exempt from federal taxes as well as state and local levies for residents in many states where they’re issued.
Distributions from retirement accounts and life insurance proceeds also wouldn’t be counted, making it even more important for high earners to maximize contributions to their 401(k) plans, Elda Di Re, area leader of the personal financial services tax division of Ernst & Young, said.
Income from passive interests in partnerships or certain closely held corporations generally will be subject to the levy, said Michael Grace, a managing director at Milbank, Tweed, Hadley & McCloy LLP in Washington.
That means taxpayers who might be affected may want to become more active in any partnership they’ve invested in, said Cox of Brown Rudnick. The tax code includes a number of ways to determine if a taxpayer is taking an active role in a trade or business such as by participating for more than 500 hours a year, Cox said.
Taxpayers shouldn’t overreact because tax laws may change again before 2013, said Steffen of Robert W. Baird.
Even with the uncertainties around tax law next year, BNY Mellon’s Doyle said he’s trying to make clients aware of scheduled increases and prepare strategies.
“It’s going to be like watching the NCAA tournament,” he said. “You never know what happens until the very end.”