It's Back - Super Effort to Tax Carry

By Julia D. Corelli, Esq., and Laura D. Warren, Esq.  

Pepper Hamilton LLP, Philadelphia, PA

On September 12, 2011, President Obama sent the American Jobs Act of 2011 (the Jobs Act) to Congress. If enacted as proposed, the Jobs Act would cost approximately $447 billion over 10 years. President Obama proposes to pay for it by, among other things, taxing carried interest (or profits-based interests issued for services), of private equity and hedge fund managers, real estate investors and venture capitalists as ordinary income, instead of capital gains beginning in 2013. The carried-interest tax would pay for approximately $18 billion of the proceeds necessary to offset the Jobs Act. Other revenue raisers include limiting itemized deductions for individuals making more than $200,000 a year and families making more than $250,000 (which is expected to generate $400 billion of revenue), eliminating oil and gas tax breaks, eliminating favorable depreciation on jets.

There may be reason for fund managers and advisors to be concerned about the carried-interest taxation proposal now, even though proposals to tax carried interest have been consistently rejected for several years. One reason is that Obama has charged the Joint Select Committee on Deficit Reduction (otherwise known as the Super Committee) with the task of raising the revenue offsets for the Jobs Act by proposing to include the tax increases as part of a broader deficit reduction plan. If at least seven of the 12 Super Committee members vote for a final proposal, the legislation would receive fast-track consideration in the House and the Senate – no amendments or filibusters would be permitted and votes would be based on simple majorities (basically an all-or-nothing vote). Thus, the general legislative process would be expedited and inertia may build in favor of passing the revenue-raising legislation (which may very well include the carried-interest tax).

The Super Committee was created as part of the Budget Control Act signed into law by President Obama on August 2, 2011, in order to raise the debt ceiling. It is a 12-member panel (six Republicans and six Democrats, equally divided between the House and Senate) charged with finding $1.5 trillion in debt savings over a 10-year period (and now an additional $447 billion). The Super Committee has until November 23, 2011, to propose ways to reduce deficits and the proposals must be voted on by December 23, 2011. If the Super Committee is not successful in producing a debt-reduction plan, as much as $1.2 trillion in across-the-board deficit reduction budget cuts would kick in. These tax cuts would be automatic and evenly divided between defense and non-defense spending, with no discretion for whether certain agencies should shoulder more or less of the hit.  The across-the-board cuts are a looming deterrent to Super Committee failure and should provide significant incentive for the committee to produce a plan.

The climate in Congress is such that, in an effort to pass something this year, the Republicans may be willing to compromise on the carried-interest taxation. Republicans, who control the House of Representatives, have signaled they may be willing to support some of the tax cuts Obama recommends. However, skepticism remains with respect to Obama's spending and tax-increase proposals.  In many ways, this is more of the same and Republicans do not want to rehash the stimulus bill.

The proposed legislation is generally less taxpayer-friendly than the last carried-interest tax bills seen in 2010. For instance, the proposed legislation does not have a gradual phase-in of the tax on carried interest and does not reduce the percentage of the carried interest subject to ordinary income rates to the extent assets are held longer-term (a provision that was included in the Senate's substitute for the American Jobs and Closing Tax Loopholes Act (H.R. 4213) last summer). It also does not exclude from the reach of the carried-interest tax any goodwill inherent in the investment services partnership interest.  The exclusions of goodwill from the carried-interest tax never appeared in prior carried-interest legislation, however, it was highly contested in 2010. Moreover, the proposed legislation tightens up certain provisions of prior bills that included carried-interest legislation. For example, it specifically captures §1231 gain and gain otherwise excluded under §1202.

Fund managers and advisors may want to consider and seek counsel as to whether steps can and should be taken to minimize the impact of a tax on carried interest. Such steps might include accelerating capital gain-generating sales, distributing shares in kind, and restructuring investments. Many funds will find it premature, or imprudent, to take any steps immediately but will want to begin planning for post-Jobs Act and 2012.

 For more information, in the Tax Management Portfolios, see Needham, 735 T.M., Private Equity Funds.

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