The debate over raising the tax rate on carried interest has re-ignited, after President Barack Obama promoted the idea indirectly in his June 29 press conference as a way to raise revenue and close the ballooning budget deficit.
Meanwhile, two other potential tax issues loom for buyout professionals, including the deductibility of interest expenses and the flow-through treatment of limited partnerships. Together with carried interest, they form what Doug Lowenstein, the president of the Private Equity Growth Capital Council, called the “holy trinity” of tax issues.
Obama didn’t explicitly name carried interest in his June 29 press conference, in which he insisted that tax increases should be a part of any deal to raise the ceiling on the federal debt. But his message was clear. For wealthy CEOs and hedge fund managers, he said, “Your taxes are lower than they have ever been.”
In light of Obama’s comment, the tax treatment of carried interest—typically the 20 percent cut of profits they take when they sell companies—is clearly in play as a bargaining chip in negotiations between Democrats and Republicans to raise the federal debt ceiling as both parties spar over how to cut the federal deficit.
Lowenstein said it was too early as yet to predict whether a tax hike on carried interest would finally pass. “I wouldn’t put it in the ‘likely’ category, but I wouldn’t put it in the ‘unlikely’ category either,” he told Buyouts. “These are very fluid negotiations. … In that kind of environment you can’t be over-confident with how something will turn out.”
Obama’s budget proposal earlier this year called for treating carried interest, currently taxed at the 15 percent capital gains rate, as ordinary income, which could be taxed as high as 39.6 percent in 2013. Such a change could raise $14.8 billion over 10 years, according to the proposal.
Legislators have proposed changing the tax treatment of carried interest several times in recent years, but such proposals have never made it to the president’s desk. Most recently, in perhaps the closest call for the industry, the chairmen of the Senate Finance Committee and the House Ways and Means Committee proposed a compromise that would have treated 75 percent of carried interest as regular income and the rest as capital gains. Ultimately, though, that provision was eliminated from the December 2010 tax bill that extended the tax cuts that President George W. Bush initiated.
Meanwhile, the Obama administration and Congress are examining long-term reforms to the tax code that could affect the ability of private equity-backed companies to deduct interest on debt payments as well as how limited partnerships are taxed.
A few months ago, Sen. Max Baucus, Democrat of Montana and chairman of the Senate Finance Committee, and Rep. Dave Camp, Republican of Michigan and chairman of the House Ways and Means Committee, requested a study on the deductibility of interest payments on debt.
Critics of the current corporate tax system say that allowing companies to deduct interest expenses encourages businesses to take on more debt, adding risk to the economy. But eliminating the tax deduction would carry other costs, business experts warn. “It would be an absolute body blow to the capital markets,” Fred Lane, vice chairman of investment banking at Raymond James, told Buyouts. “Forget just the buyout business—it would kill a lot of things. The stock market would go in a swoon.”
However, simply because Baucus and Camp requested the study does not mean they will share the same conclusion as to how tax deductions on interest payments should change, if at all, Lowenstein said. But it is an indication that legislators are keeping all options on the table.
The study, being conducted by the non-partisan Joint Committee on Taxation, could be finished in August or September, Lowenstein said. Representatives from the offices of Baucus and Camp did not return calls seeking comment. Officials at the Joint Committee on Taxation declined to comment.
The Obama administration is also looking at creating an “entity tax” for investment partnerships, limited liability companies and S corporations, all of which are “flow-through” structures that are commonly employed by tax-savvy private equity firms. Like most large corporations, private equity firms could eventually face two sets of taxes, one at the entity level and one at the individual partner level.
To be sure, neither of the latter two tax proposals will come to a head any time soon, and both would face fierce resistance from the private equity industry and many other interests. In May, Rep. Erik Paulsen, Republican of Minnesota, told a conference of certified public accountants that any proposal to begin taxing partnerships like corporations would be “dead on arrival” in the House, according to BNA Banking Daily, which follows banking legislation.
But the mere fact that congressional leaders are scrutinizing these aspects of the tax code should give private equity professionals pause for concern, Lowenstein said.
“Those of us in private equity would be asleep at the switch if we didn’t acknowledge those risks and begin now to think about how we will position ourselves,” he said, adding that “these are unwise places to go because it would depress growth capital investing at a time of continued need for growing the economy.”