Higher Taxes A Top Concern For Obama’s 2nd Term

  • Carried interest looms large
  • Concern over fiscal cliff
  • Comprehensive reform is distant

The first test is likely to come before the end of the year. The administration and congressional leaders have already begun sparring over a lame-duck session that could address a handful of the most pressing issues, including the well publicized fiscal cliff that could occur on Jan. 1, when the Bush-era tax cuts are scheduled to expire and when a package of spending cuts could take effect on major military and entitlement programs. Those talks are likely also to address the next increase in the federal debt ceiling, an issue that tripped up Congress in 2011.

Obama already has said he opposes an extension of the Bush tax cuts for high-income earners, a move that could raise taxes for many buyout pros—on regular earned income, capital gains and dividends—even if negotiators find a way to avoid the broader tax increases that could be triggered by the fiscal cliff. Should we go over the fiscal cliff with no new legislation the rate on capital gains would jump from 15 to 20 percent; the rate on dividends would go from 15 percent to ordinary-income rates.

As a new Congress convenes in 2013, a range of tax increases—including the passthrough tax treatment of partnerships, a key benefit for limited-partnership funds, the deductibility of interest on debt and limits on deductions for charitable contributions—also could be on the table. Another likely issue will be a narrower differential between the tax rate on capital gains and that on regular income. The net result is likely to mean higher taxes for financial sponsors, across the board.

For buyout pros, the looming issue is over carried interest, the tax-advantaged treatment of fund management fees that enables them to pay the 15 percent capital gains tax rate on a large portion of their earnings, rather than the top ordinary income tax of 35 percent. Obama has said in the past that he favors eliminating the tax break, and Vice President Joe Biden brought the issue up, unbidden, in his debate with Rep. Paul Ryan, the Republican candidate for vice president.

A certain fatalism seems to have settled over the industry about the fate of the capital-gains treatment of carry. Leon Black, the chief executive of Apollo Global Management, said in an interview with sister news service Reuters that that such a move was now likely, adding that it might have come into play even if Mitt Romney, the former Bain Capital executive who carried the GOP banner, had prevailed in the presidential race.

“I think carried interest was on the table whoever won,” Black said. “The fact is we have a big deficit and both parties are going to have to look at different sources of revenues.”

The carry question also came up frequently during the Buyouts Texas conference this month in Dallas. For some, the only question has to do with timing. As Kevin Conway, managing partner of Clayton, Dubilier & Rice, put it during a keynote interview, “I would be surprised if [the proposal went] away, but I would be surprised if it happened in the next few weeks.”

Others, however, plan to fight to preserve the tax break on carry. Brett Palmer, president the president of the Small Business Investors Alliance, a Washington, D.C.-based trade group that lobbies on behalf of small-company investors, speaking at Buyouts Texas, called the challenge on carry “an existential threat” to smaller firms, which could lose the next generation of investing pros to more lucrative opportunities.

“Carry is what keeps young investing professionals with smaller funds,” Palmer told Buyouts later. “Your payday is 10 years down the road when your investors are happy and you’ve earned them great returns.”

Carry is disproportionately important to smaller buyout shops, Palmer argued, because while their assets under management, and their payouts on successful investments, are much smaller than those of their larger rivals, their expenses—for staff, office space, research and other obligations—are not commensurately lower. Thus, he said, a higher tax rate could mean the difference between a successful small-business investor and one that is out of business.

That is the message that the SBIA plans to take to Capitol Hill on behalf of its 200-odd members, a roster that includes buyout shops including The Riverside Company and Tonka Bay Equity Partners. “It’s going to be hard to defend as a standalone issue,” Palmer acknowledged, but he said the small-company argument might resonate with members of Congress. “Smaller funds are the only ones that can invest in small business.”

As a practical matter, however, the treatment of carry as capital gains is less likely to be part of the fiscal cliff debate and more likely to be part of the bigger discussion of taxes and spending that Washington watchers expect to begin in 2013.

“The fiscal cliff does loom large,” acknowledged Steve Judge, president and CEO of the Private Equity Growth Capital Council, a trade group representing 36 members, mainly large and mid-market buyout firms. Some partisans believe that Congress can afford to go over the cliff, writing retroactive legislation next year to restore some elements of the tax breaks and spending that will be eliminated. But politicians face a hard stop on the debt limit, coming early in 2013, where last year’s brinksmanship led to a downgrade of the United States’ sovereign debt rating, Judge said. “That is a real action-forcing event.”

In the coming debate over tax and spending, carry will be only one of many business-related issues that the government must take up, including the federal debt, entitlements such as Social Security and Medicare, and military spending. In that context, carry is likely to be part of a larger debate over the preferential tax treatment of capital gains.

Comprehensive tax reform also will be likely to address the taxation of partnership entities (which today are not taxed at the firm level, only by the individual partners) and the deductibility of interest payments on debt. The council was concerned enough about that last question to commission a study by audit firm Ernst & Young, which reported in May that limiting the interest deduction would adversely affect investment and impede economic growth.