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House Democrats Introduce Bill to Tax Carry at 35 Percent

Tax Alert

Authors: Joan C. Arnold and Steven D. Bortnick

6/25/2007

On Friday, June 22, Representative Sander Levin (D-Mich.) was joined by 12 other members of the House Ways and Means Committee in introducing a Bill that would have fund managers taxed at 35 percent on all income earned through a carried interest. The Bill would affect partnerships investing in securities, real estate and commodities, plus all derivative instruments related to those assets. Income earned by fund managers attributable to capital invested in the fund would be excepted from this new rule and would continue to be taxed at the lower capital gains rate.

Currently, income earned through a carried interest is taxed to the investment manager according to the nature of the source of the income. If, as is common in private equity funds, income is earned through the sale of a capital asset with a long-term holding period, the fund manager is taxed at the preferential 15 percent long-term capital gains rate. This Bill would change that. In addition to taxing income from the carry at 35 percent, the Bill also calls for sales of fund managers’ partnership interests to generally be taxed at 35 percent, and for distributions of property to fund managers to be treated as if the property had been sold, so that deemed gain is taxed at 35 percent. The Bill also calls for income from a carried interest to be treated as “earnings from self employment,” subjecting it to social security tax of 12.4 percent on the first $97,500 in income and medicare tax of 2.9 percent on total income.

The authors of the Bill did not identify an effective date. While Ways and Means chairman Charles Rangel (D-NY) has stated in the past a preference against enacting tax legislation with an effective date prior to its date of passage, he noted last week that this may be the time that retroactivity is appropriate. Committee hearings on the Bill will be scheduled for July.

Motive

The stated motive for the Bill is “tax fairness.” In connection with the June 14 introduction of a Bill in the Senate to tax publicly traded partnerships as corporations (see Pepper Hamilton’s Tax Alert on the Bill), Senators Max Baucus (D-Mont.) and Chuck Grassley (R-Iowa) expressed their view that the managers of investment partnerships earn income from rendering investment advisory services. The authors of this current Bill share that view. They feel that principles of tax fairness require that compensation for services be treated as ordinary income, regardless of its source. There is also purportedly an issue of fair competition – other financial services firms that directly and indirectly compete with investment partnerships are generally compensated on a fee basis rather than through carry. This income is generally taxed at the 35 percent ordinary income rate.

There is also speculation that this Bill could gain support as a possible way to pay for overhaul or repeal of the Alternative Minimum Tax. All tax cuts passed in Congress must be accompanied by other provisions that will increase tax revenues such that overall, the tax legislation is revenue neutral. Revenue projections of this Bill are expected to be substantial.

Opponents of the Bill, including the Private Equity Council, have argued that Congressional motives are driven by politics, not good tax policy. They view the Bill as a revenue grab from an industry that has been publicized as generating substantial income.

Pepper Perspective

Although the issue of taxing carried interests has been under study by both Congress and Treasury for months, the issue was brought to the forefront by the recent Blackstone IPO, and media reports of the wealth created by it. It is not certain whether, if media coverage of Blackstone and the rest of the industry fades, attention to taxation of carried interests will as well.

Tax practitioners also believed that even if Congress were willing to tax certain large hedge funds and private equity funds, Congress would be sympathetic towards venture capital funds, which were thought to be viewed as working to grow businesses and provide jobs. This Bill does not reflect any sympathy towards venture capital – managers of venture capital funds would be subject to the same ordinary income tax rate as any other fund manager.

If the Bill maintains momentum and passes the House, there is already speculation in the tax community about whether the Bill could survive a vote to end debate in the Senate or a possible Presidential veto.

Joan C. Arnold, Steven D. Bortnick and Benjamin M. Hussa

This article is informational only, and should not be construed as legal advice or legal opinion on specific facts.