Targeting a Valuable Tax Break for Wall Street

In 2010, Congress considered legislation that would target the taxation of so-called “carried interests.”  Commentators and politicians have increasingly criticized carried interests, portraying them as a loophole.

By way of background, investment funds (including private equity, venture capital, hedge fund, and real estate) are generally formed as limited partnerships.  As limited partners, investors- often institutions or wealthy individuals- contribute money and hope for a return on their passive investments. The general partner is essentially the manager of the fund.  As the general partner, the manager receives a certain percentage of the fund’s annual profits from investments; this percentage varies from fund to fund but is generally around 20 percent.

The portion of a fund’s profits that is derived from long-term capital gains qualifies for preferential tax treatment.  In 2012, the tax rate on long-term capital gains for high-income taxpayers was 15 percent.  In 2013, that tax rate increases to 20 percent, but there is also a 3.8 percent tax on investment income starting in 2013.  Even with the 2013 increase, long-term capital gains are taxed at much lower rates that wages.  A person paying 23.8 percent on long-term capital gains would pay over 40 percent if those gains were treated as wages.

The criticism of carried interests is that they are treated as the manager’s long-term capital gains even though they are in reality compensation for the manager’s services.  Critics argue that the reason for the preferential tax treatment of capital gains- to encourage investments- is not applicable to the manager of investment funds because the manger is not really earning a return on his investments, but rather is being compensated for labor.

If critics of carried interests win the day and succeed in taxing a manager’s compensation at higher ordinary income rates, they plan to go one step further.  They reason that a fund manager who is facing ordinary income rates on his profits might attempt to game the system by selling his general partnership interest.  Under Section 741 of the Internal Revenue Code, gain from the sale of a partnership interest held for more than one year is long-term capital gain and qualifies for preferential tax treatment (although Section 751 provides certain exceptions to this rule).  Thus, a fund manager who expects to receive $5 million in profits from his fund in a given year (taxable as ordinary income under the proposed law) may choose to sell his fund interest and thereby treat the profits as long-term capital gain.

Concern over this possible circumvention has led some commentators to call for a backstopping “enterprise value tax (EVT).”  The EVT would provide that sale from an investment services partnership interest would be taxed as ordinary income.  A version of the EVT proposed (but not enacted) in 2010 that will likely serve a starting point for any future legislation drew fierce opposition from the investment fund industry as well as some tax experts.  They attacked the proposed bill for sweeping too broadly in that it sought to tax gain from the goodwill of the business as ordinary income, not just the manager’s shares of the fund’s annual profits.  This treatment would be in contrast to other industries, where gain from the sale of a business that is attributable to goodwill is treated as capital gain.  In addition, the 2010 legislation was so broad that it could arguably apply to an operating business (such as a manufacturer) that held a small portfolio of investments.

Given the ever-louder calls for an overhaul of the tax code, it is highly likely that Congress will take action on carried interests during President Obama’s second term.

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