The federal government is once again considering changing how it taxes the profit that buyout fund managers make when they sell companies. Other tax battles also loom for the industry, including ones over the introduction of taxation at the partnership level and the deductability of interests expenses
President Barack Obama‘s recent budget proposal would treat carried interest as ordinary income rather than capital gains. Such a change would raise $14.8 billion over 10 years, according to the proposal.
The issue is a critical one for private equity firms because they strive to make the majority of their money on carried interest, the 20 percent cut of profits they take when they sell companies (assuming they have cleared a set of hurdles determined in their partnership agreements). Fund managers now pay a 15 percent capital gains rate on that profit, but would have to pay as much as 39.6 percent come 2013 if that money were treated as ordinary income.
In what feels like an annual ritual, legislators have several times proposed raising the tax on carried interest. But each time the industry has managed to avoid the change, most recently last year when it was not included in the December tax bill that extended the Bush tax cuts. Still, some saw it as a close call, particularly after Sen. Max Baucus, chairman of the Senate Committee on Finance, teamed up with Rep. Sandy Levin, then chairman of the House Committee on Ways and Means, on a compromise proposal that would treat 75 percent of carried interest as regular in come and the rest as capital gains.
Some private equity officials saw the inclusion of carried interest as a pure political move on the part of the president as he readies his re-election campaign. “I think this is an ideological issue for the president,” Alex Slusky, founder of the technology-focused buyout firm
Officials with the Private Equity Growth Capital Council, the industry’s lobbying organization, remain skeptical that carried interest will make it into the final budget. They believe the Republican-led House of Representatives will vehemently oppose any form of tax increases and are in no mood to negotiate.
“Over four years Congress has consistently rejected proposals to raise taxes on carried interest because lawmakers have concluded it is nothing more than a tax increase on job creation and growth investments,” said Doug Lowenstein, the president of the council, in a prepared statement. “We believe bipartisan congressional opposition to carried interest tax hikes is even stronger today than in previous years and we do not believe the administration’s latest proposal will generate much support.”
When news broke about the president’s carried interest proposal, many were curious how the government came up with its estimate of the revenue to be gained by the tax over ten years, $14.8 billion. The president’s previous budget had estimated the tax would raise $24 billion. One possible reason for the lower estimate is if the proposal is following the scaled-back Baucus-Levin compromise.
“The basic idea is that the proposal was narrowed to focus on financial sector partnerships where the potential for converting service income into favorably taxed capital gains is greatest,” an official with the U.S. Department of the Treasury, which calculated the revenue gain, told Buyouts. “The revenue estimate reflects this more targeted approach.”
Meantime, other tax issues are brewing on the horizon for the industry, as talk builds of Congress tackling broader tax code reform.
Specifically, some fear that as momentum increases to lower the 35 percent corporate tax rate, legislators may seek to broaden the base of those who pay it so that it doesn’t generate less revenue. Kevin Hassett, director of economic policy studies for the American Enterprise Institute, has recently called for a broadening of the corporate tax base, while Treasury Secretary Timothy Geithner has signaled a willingness to lower the corporate tax rate while keeping it revenue-neutral.
Broadening the corporate tax rate base could include investment partnerships such as private equity funds, in which today the tax liability flows through to the individual members, according to one lobbyist who works for mid-market funds.
Another looming matter is the possible elimination of the deduction on interest on corporate loans. This deduction allows private equity-owned companies to deduct the interest they pay on the debt its owners use to buy it. President Obama’s deficit commission recently identified the mortgage-interest deduction as a possible revenue source.
The lobbyist following these issues doesn’t expect them to change anytime soon. A lot depends on the outcome of elections in 2012, and if republicans attempt to re-write the tax code. But, he said, “the point that some people forget is, even now, there are hearings and debates going on about this, and if you don’t get into the debate now and fight the fight, you’ll be out of time.”