Why US fund managers may be taking home less carry

Thought the campaign behind a carried interest tax hike died last year? Think again, writes Jenna Gottlieb.

Many industry players were sure the momentum for a carried interest tax increase died last year when a new Republican Congress took control. Not so. US President Barack Obama’s budget proposal puts a tax hike firmly back on the table.

Obama’s proposal directs Congress to require executives of private equity firms to pay ordinary income tax rates (as high as 35 percent) on the profits they receive as compensation. Carried interest currently qualifies for lower capital gains tax rates of 15 percent.

While the proposal appears to be a scaled-back version of what the Senate considered last year, as the president’s previous budget’s proposal on carried interest would have raised $24 billion in tax revenues over 10 years and this one would generate $14.8 billion over the same period, Obama should expect some push-back from House Republicans.

“Republicans are tired of this fight, but here they go again,” said a tax attorney based in New York. “A lot of people thought [Senator Max] Baucus’ failure last year would be the end of the [carried tax] discussion.”

In December, US Senator Max Baucus, a Democrat, dropped a provision in the contentious tax cut bill that would have more than doubled taxes on carried interest. The Senate bill would have prevented general partners from paying taxes entirely at the capital gains rate on carried interest. Under certain rules, up to 75 percent of carry could have been treated as ordinary income beginning this year.

Baucus’ effort ended in December and the private equity community declared victory, having for years fought against Baucus’ (and other Congress members’) various bills that have proposed the redesignation of carry tax. In 2007, when Congress’ interest in carry tax seemed to reach a pinnacle, one tax expert remarked that the issue was probably the most lobbied tax provision in more than 20 years.
 
But the renewed debate may be tougher to fight.“House Republicans want to address the deficit. And while carried interest would be a drop in the bucket [in terms of plugging deficit holes], Republicans can no longer blindly protect big business,” said a tax attorney. “Private equity is part of it, no doubt. Congressmen are going to pick their battles more carefully. So, Obama has a chance even with a Republican House.”

President Obama managed to reignite this debate in, of all places, a brief line item in his proposed budget, which means the industry will have to wait for specifics. But it looks like US GPs may have to accept the prospect of higher taxes on the horizon.