CARRIED INTEREST INQUISITION(2)

A state of fear (or, at least, nervousness) has gripped the private equity industry ever since it became known that certain congressmen had taken an interest in the fact that carried interest is “only” taxed at 15 percent. One of these lawmakers, Senator Chuck Grassley, a Republican from Iowa and ranking member of the Senate Finance Committee, has cultivated a reputation as an enemy of tax shenanigans.

General partners have rightly sensed a political vulnerability on this issue. Put in stark terms, 99 percent of the public couldn't give a rodent's derriere that a handful of private equity guys might have to pay 35 percent on carried interest payouts instead of 15 percent. What's more, the average politician will get so much more mileage out of claiming to have put the kibosh to billionaire tax gamesmanship than from claiming to have fought hard to protect the capitol gains status of carried interest.

Fueling the interest in carried interest among lawmakers is the need to raise tax revenue through means other than a general tax hike. There is growing discontent among middle-class voters about the Alternative Minimum Tax, a tax system that was originally designed to deny the wealthy certain write-offs, but which is now increasingly biting into the incomes of middle-class families. Congress needs revenue to offset and changes made to the AMT.

All this begs the question, are there any natural allies of the 15 percent carried interest tax on Capitol Hill? Fortunately for GPs, there are at least two. Most conspicuously are the private equity lobbying groups, the NVCA and the new Private Equity Council. Arguably a more important ally, however, is the mindboggling complexity that lawmakers will face in trying to change the tax on carried interest without stirring up a hornet's nest of related issues.

While it's safe to say that a tax hike on carried interest isn't imminent, Washington insiders confirm that lawmakers have begun studying the issue. Mary Kuusisto, a partner at law firm Proskauer Rose who has been retained by the NVCA to assist in Capitol Hill lobbying, says relevant members of Congress are “taking this very seriously, which means that we are looking at this very seriously”.

Standing in the way of a change to the tax rate on GP carried interest are several concepts that are fundamental to the US tax code, as well as to partnership law in general, notes Kuusisto. Advocates of the tax hike argue that carried interest is a fee, not a true capital gain, because most of the capital at risk is not that of the GPs but instead that of clients. Therefore, carry should be treated like ordinary income, goes this argument.

But tax considerations are based on the source of the underlying income, not on the circumstances of the ultimate beneficiary of that income. Carry is taxed as capital gains because it is derived from what are indisputably the capital gains of the limited partnership. How the partners in the partnership choose to divide the spoils is really their own business. “To make a change is to say that we're not going to respect the partnership form,” says Kuusisto, who adds that many other entities are structured giving certain partners a disproportionate share of the profits.

For inquisitive lawmakers, the water is further muddied by the difference between hedge funds and private equity funds. Whereas private equity and venture capital funds tend to involve extremely illiquid investments held over long periods of time, most hedge funds involve liquid securities that are marked to market at the end of the year to determine the incentive fee, aka carried interest. The use of offshore partnerships by primarily hedge funds only adds to the complexity of the issue.

While lawmakers marshal the facts, they will be hearing from the NVCA and also the Private Equity Council, newly formed by the largest buyout firms, about how private equity's growth has led to tremendous wealth creation, job growth, and the formation of entire industries.

The members of Congress will also likely encounter a recurring question in studying carried interest, that being whether capital gains should be given preferential treatment in the first place. Tax rules are powerful incentive structures, and rewarding the gains of long-term investment over “ordinary income” sets in motion powerful market forces. Isolating carried interest may ultimately be seen as a long road to a small place.