Carried Interest Taxation

Representative John Larson (D-CT) has proposed legislation (H.R. 3417) that would form a bi-cameral committee, consisting of 3 House and 3 Senate members, to study the Federal income tax treatment of private equity and hedge funds.  Such legislation would study issues broader than carried interests, but clearly would address the tax rules for carried interests.

Representative Larson, who has acknowledged the importance of private equity and hedge funds in Connecticut, appears to be straddling the fence and trying to slow down a train trying to gain a little momentum.

Ways & Means Committee Chairman Rangel (D-NY) announced that he will hold hearings beginning on September 4 on a larger "tax simplification" proposal that would include permanent alternative minimum tax relief.  Rep. Rangel indicated that carried interest legislation would be a piece of this larger tax reform proposal.  However, he also stressed that Congress was not targeting private equity in its goal of tax reform.

Bruce Bartlett, former Treasury economist in the Reagan administration, argues in today's WSJ that capital gains are not income at all,  and thus should be exempt from Federal income tax.    While Bartlett's argument is based on some interesting historical cases, we don't see a broad movement to restore the tax system to Civil War times.  And of course, a complete exemption for capital gains would only ratchet up the demand for innovative ways to convert capital gain into ordinary income.

Yesterday, the Senate conducted its second round of hearings on the carried interest issue, where some of the following notable developments occurred:

• William Stanfill, manager of a small venture capital fund, testified in support of raising the tax rate on carried interests.  While Chairman Baucus stated that Stanfill's views are representative of the private views of many fund managers, we remain skeptical.
• Bruce Rosenblum, of the Carlyle Group (and chairman of the Private Equity Council), argued that private equity fund managers should be equated with the entrepreneurs of the portfolio companies in which funds invest, because the managers take active roles in managing those businesses.
• Democratic Senators Kerry and Schumer continue to signal antipathy toward the current legislation proposed in the Senate and the House.

We also continue to hear some drumbeats about eliminating the preferential rate for capital gains altogether.  We continue to believe that such a measure would not have any broad support in the current political environment, but it is interesting to hear this talk again 20 years after its last appearance.

The NYT  has more on Senator Schumer's strategy to oppose carried interest legislation that doesn't include real estate and oil and gas partnerships.  The Times characterizes this position as a "poison pill," but this question is worth asking.  Assuming that returns on carried interests should be taxed as ordinary income regardless of the character of the asset that produces those returns, why shouldn't the same rule apply to managers of real estate funds and oil and gas investment funds?