Carried interest is now officially in play.Since Obama won reelection, the tax rate that is near and dear to the hearts of private equity firms and hedge fund managers (and also the real estate industry) is going to be discussed.
And by discussed we mean potentially put on the chopping block.
First, here’s how the Tax Policy centre defines carried interest:
Carried interest is a right that entitles the general partner (GP) of a private investment fund to a share of the fund’s profits (see figure 1). Typically, the GP contributes 1 to 5 per cent of the fund’s initial capital and commits to managing the fund’s assets. In exchange, the GP receives an annual management fee of 2 per cent of the fund’s assets plus a “carried interest” of 20 per cent of the fund’s profits that exceed a certain “hurdle” rate of return. The individual partners of the GP, not the GP itself, are taxed on these payments.
In short, carried interest is a huge part of how Wall Street investment firms get paid.
Proponents of the lower rate argue that Wall Street takes a risk with this money. Opponents say it’s a loophole and should be taxed at a normal rate because it’s not at risk at all since investors usually set it as a part of their payment structure ( the old, 2% and 20%).
Either way, now that the Obama administration is looking for ways to raise revenue, though, carried interest is a target.
Here’s what David Rubenstein, founder of private equity firm the Carlyle Group, said about it, according to Businessweek:
“After the lame duck, we expect that comprehensive tax reform will likely be on the agenda of the new Congress and the president,” Rubenstein, referring to the period after the new Congressional session begins on Jan. 3, said on a conference call today discussing his firm’s earnings. “Carried-interest taxation and a great variety of other issues will no doubt be addressed.”
All in all, this is an old dance. Since 2007, Congressman Sander Levin (D-MI) has raised the carried interest issue in the House 3 times. Ultimately, his attempts to raise the rate have always been thwarted in the Senate.
Back in 2010, carried interest was left alone as part of a deal between Obama and Republicans that also continued Bush era tax cuts.
This year, Levin brought the issue up in February in a bill called the Carried Interest Fairness Act. Last we checked, it’s been stuck in the Ways and Means Committee since February.
But to be fair, as Peter Orszag pointed out in his 2007 Congressional testimony about the rate, that even Ronald Reagan raised the capital gains rate to 28% in his 1986 budget because he had to make the maths work.
Point is, this isn’t necessarily a partisan issue. It’s an arithmetic issue.
Even former presidential candidate Mitt Romney had to admit that carried interest may not be as risky as Wall Street makes it out to be, but he punted the decision of figuring out whether or not the rate should be raised to the IRS and the judicial system.
“I think you have to look at each dimension of our income streams and ask if this is a true capital gain or carried income. And you look to either the Courts or the IRS to and look at the various structures and investment vehicles and say ‘gosh is this a true capital investment with the risk of loss or is it instead ordinary income with no particular risk of loss. If it’s ordinary income you should treat it as ordinary income and if it’s capital gain you should treat it as capital gain. I don’t believe that it’s Congress’ job or the Administration’s job to say ‘hey these people are making to much money lets change their tax rate to make them less able to be financially successful.’ I think you do however need to apply the code in a way that’s consistent across the board.
With the Obama Administration dead set on raising revenue, expect no punting of this nature. Carried interest will likely be filed under the ‘loophole’ moniker as Wall Street fears, and that’s one way to ensure that the matter gets discussed one way or another.
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