GOP senator may push for PE tax changes

Federal legislators are mulling a proposal to treat carried interest compensation for private equity and hedge fund professionals as ordinary income rather than capital gains.

The move would instantly propel the biggest pool of private equity compensation into a much higher tax bracket. Salaries and bonuses earned by private equity professionals come from fund management fees and are treated as ordinary income. But the lofty sums they earn above that derive from their 20% profit share, or carried interest.

Carried interest is the profit slice that private equity firms carve out for themselves after selling portfolio company positions at a cost-basis gain. Since such gains are based on long-term investment success, they have traditionally been classified as capital gains and therefore taxed at 15 percent. Under the proposal now taking shape, carry would be treated as ordinary income, and therefore taxed at a 35% rate for professionals in the highest tax bracket. This would be a significant change not just from an accounting perspective, but also from a take-home pay perspective. After all, it would more than double the taxation on profits enjoyed by private equity firms.

Advocating the proposal is Charles Grassley of Iowa, the ranking Republican on the Senate Finance Committee, which is led by Democratic chairman Max Baucus of Montana. Baucus and other Democrats have said that they would focus on executive compensation and taxation of the wealthy since taking control of the U.S. Congress in January. The fact that a Republican such as Grassley has joined the fray should give the carried interest tax proposal even more momentum.

Currently, Grassley and his staffers are only floating the notion of a carried interest tax. No legislation has been authored.

“I think it’s going someplace,” says Richard J. Bronstein, a tax partner at Paul, Weiss, Rifkind, Wharton & Garrison in New York. A representative from the Senate Finance Committee declined to comment except to say that there are no plans for creating a bill at the moment.

The change in tax treatment for carry would join a growing list of initiatives gaining traction in Congress, including the possibility of raising the top income tax rate from 35% to 39.6% and increasing the capital gains rate from 15% to 20%, according to law firm Debevoise & Plimpton.

Notably, Baucus and Grassley have been critical of alternative investment funds. Because these funds rely heavily on public pension funds for capital, the lawmakers have questioned whether they operate with sufficient transparency and whether they return enough money to investors.

In a statement, Douglas Lowenstein, the president of the newly formed Private Equity Council, an educational and lobbying association working on behalf of the industry’s largest firms, said the carry-tax issue is one of many topics he plans to discuss as he makes his first rounds through congressional offices.

However, Grassley’s intentions with the carried tax rate proposal already seem clear. Last week, Grassley introduced an amendment to regulate hedge funds. “The secretive way that hedge funds operate might not be an issue for the super rich who first invested in hedge funds, but today the average Joe has a stake as pension funds are invested in hedge funds,” Grassley said on the Senate floor. “Right now a hedge fund isn’t required to report even basic information about who runs the fund.”

His amendment didn’t pass, in part because he has no authority over hedge funds, which are more the domain of the Senate Banking Committee.

Dan Primack contributed to this report.