Private Equity’s Carried Interest Eyed by Congress: Taxes

The preferential tax rates that private-equity managers pay on some profits survived Congress’s Jan. 1 budget deal. That victory may not last.

“It’s still alive,” said Andrea Whiteway, a partner at Chicago-based McDermott Will & Emery LLP who works in Washington. “Carried interest is still an issue that’s on the table as far as possible revenue raisers, loophole closers.”

For private-equity managers, changes in the tax treatment of so-called carried interest may affect them more than tax increases now on the books. Congress faces a series of deadlines in the next few months over spending cuts, the debt ceiling and the annual budget. Democrats including President Barack Obama want to raise more revenue, and carried interest is an obvious candidate.

“There continues to be no rationale whatsoever for people to pay at a vastly lower tax rate when they are managing other people’s money,” Representative Sander Levin of Michigan, the top Democrat on the House Ways and Means Committee, said in an e-mail. “This is an issue of fairness that we should address as we seek a balanced approach to deficit reduction that involves both additional revenues and spending cuts.”

The share of profits in buyout deals, known as carried interest, is often taxed as capital gains, which receive preferential rates under the tax code compared with levies on wages. In the budget deal, lawmakers increased the top rate on long-term capital gains to 20 percent from 15 percent and the maximum rate on ordinary income to 39.6 percent from 35 percent.

Rate Differential

The big rate differential between capital gains and ordinary income makes it likely that carried interest could lose its tax treatment, said Whiteway, who heads the practice dealing with partnerships for the McDermott law firm.

Democrats including Levin have sought to tax carried interest as wages for more than five years, saying private-equity managers’ compensation should be treated like workers’ salaries. Obama’s most recent budget plan called for this change, which would raise about $16.8 billion over 10 years, according to the Joint Committee on Taxation.

The president repeated his desire to limit tax breaks in in his weekly address on Jan. 5. In a Jan. 6 interview on CBS Corp.’s “Face the Nation,” House Minority Leader Nancy Pelosi, a California Democrat, identified carried interest as a tax break that should be reviewed in coming negotiations over the budget deficit.

Republican Resistance

Democrats face resistance from Republicans as lawmakers gear up for a fight next month over the U.S. debt. Senate Minority Leader Mitch McConnell, a Kentucky Republican, said Jan. 6 on ABC’s “This Week” program that further tax changes are off the table.

The private-equity industry and other investors will incur an increase in taxes paid on capital gains as a part of the recent budget deal, Steve Judge, president and chief executive officer of the Washington-based Private Equity Growth Capital Council, said in an e-mail. The group represents about 35 private-equity firms including Blackstone Group LP and Carlyle Group LP.

“Carried interest is appropriately taxed as a capital gain and is commonplace in venture capital, real estate and private equity partnerships,” Judge said. “Given the industry’s recent contribution to deficit reduction, it is our hope that any tax reform effort in 2013 will be about crafting policies that incentivize economic growth.”

Budget Deal

The Jan. 1 budget deal that averted most of the $600 billion in tax increases and spending cuts scheduled to take effect this month -- known as the fiscal cliff -- raised the top rate on capital gains to 20 percent. The 2010 health-care law tacks an additional 3.8 percent surtax on investment income of high earners starting this year, bringing the maximum rate to 23.8 percent from 15 percent. That’s a 59 percent increase.

For private-equity managers, a change to the treatment of carried interest could have a much bigger effect, said Hunter Payne, partner and general counsel at McLean, Virginia-based Harbour Capital Advisors LLC.

If carried interest were taxed as ordinary income, the top rate on such profits would increase to 39.6 percent. High earners also face a 0.9 percent added tax on wages starting this year as a result of the health-care law. That means the top rate would be 40.5 percent compared to 23.8 for capital gains, or a 70 percent rise.

“The magnitude of that potential increase is much higher,” said Payne, whose firm advises high-net-worth individuals, including private-equity managers. Many private-equity managers receive the bulk of their income through carried interest, he said.

Presidential Campaign

Carried interest may be an easy target if lawmakers in coming months go after tax breaks in the code, Payne said. “The general public may not have a lot of sympathy for it,” he said.

The 2012 presidential campaign focused attention on the taxation of private-equity managers because Republican nominee Mitt Romney, the former chief executive officer of Bain Capital LLC, built his wealth in the industry. Romney’s 2011 tax return showed he paid a 14.1 percent federal tax rate on $13.7 million of income because much of his income was taxed at preferential rates.

Congressional Scrutiny

Heads of private-equity firms including David Rubenstein, who co-founded Carlyle Group, indicated in November that they expect carried interest to be among the tax breaks that the new Congress will scrutinize.

“Carried-interest taxation and a great variety of other issues will no doubt be addressed,” Rubenstein said Nov. 8.

Billionaire George Roberts, who runs the private-equity firm KKR & Co. with his cousin Henry Kravis, said on Nov. 14 that “it would be good to look at everything in the tax code” to make it simpler and fairer. Roberts has an estimated net worth of $4.4 billion, according to the Bloomberg Billionaires Index.

Still, the tax treatment of carried interest may not be changed because the budget deal didn’t include an overhaul of deductions or expenses in the tax code, said Libby Cantrill, who focuses on public policy issues for the asset management firm Pacific Investment Management Co. based in Newport Beach, California.

‘Less Likely’

“We think tax reform is much less likely now than it was in the fall of 2012,” Cantrill said. “As a result, it’s likely we’ll see things like carried interest preserved.”

If tax law changes are made affecting carried interest, private-equity managers may have incentive to sell appreciated investments or restructure partnerships before new rules would take effect, Whiteway of McDermott said.

Last year, some private-equity managers moved to take advantage of the preferential rate on capital gains including carried interest. They refinanced investments, accelerated gains on deals and shifted what they transferred to trusts.

People who receive carried interest are still bracing for changes, said Jim Brown, partner in the tax group at Willkie Farr & Gallagher LLP in New York.

“They fear that it is on the table and they’re hopeful that it won’t come to pass,” said Brown, who specializes in the interests of investors and funds. “I would expect it would be part of the negotiations of any tax reform effort.”

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