Hill Staff Sees Changing Attitudes on Taxing Carried Interest; Could Be Part of Tax Reform

By Aaron E. Lorenzo  

Congressional sources signaled a shift in thinking on carried interest taxation, suggesting that an Internal Revenue Service official's recent forecast for pending change might not be too far off base.

In short, there appears to be an increased willingness on Capitol Hill to treat carried interest compensation as ordinary income instead of taxing it at the capital gains rate. None of the Senate Finance or House Ways and Means committee aides that spoke to BNA denied the prospect of such a change, though they agreed that it only seems likely to advance as part of a wider package of tax reforms, which has yet to come together.

“The committee will go line by line through the code to see what is working and what isn't,” a senior Ways and Means aide said, noting that would leave Chairman Dave Camp (R-Mich.) with a clean sheet of paper to decide what to add back. “So, every policy is under consideration.”


 

“Carried interest is labor income and ought to be taxed as such.”

 

 

 

Victor Fleischer, law professor

But Camp's discussion draft on changing partnership taxation did not address questions about taxing carried interest. Still, the issue is clearly on his radar and a legislative change could be included in a smaller package of tax reform proposals, according to University of Colorado Law School professor Victor Fleischer, should lawmakers fail to coalesce around a broader overhaul.

'No Rationale.'

“There continues to be no rationale whatsoever for people to pay at a vastly lower tax rate when they are managing other people's money,” Ways and Means ranking member Sander Levin (D-Mich.) told BNA.

Individuals receiving income from carried interest get it as a share of profits--typically 20 percent--from investments they have managed. Fund managers are also often paid a fee, often around 2 percent, for managing the investments. Critics say the fund managers benefit from the lower long-term capital gains rate--currently about half of the top ordinary income tax rate--even if they are putting little to no money in the investments and have little to lose.

Levin, who is on the verge of reintroducing legislation to treat carried interest as ordinary income, has rolled out three previous carried interest bills, dating back to 2007. Advocates outside Congress, including Fleischer and Steve Rosenthal, a visiting fellow at the Tax Policy Center, indicated that they see a greater sense of acceptance, even among elected officials and some in industry who have voiced opposition in the past.

“Carried interest is labor income and ought to be taxed as such,” Fleischer told BNA. “That's the basic policy message that's driving toward consensus on the issue.”

Carried Interest Reform 'a Real Possibility.’

Speaking in Chicago April 30, Clifford Warren, special counsel to the IRS associate chief counsel, suggested that carried interest policy reform “is a real possibility” because the matter has been bandied about over and over again at this point (84 DTR G-8, 5/1/13).

Among those who have repeatedly pushed the issue is President Obama, who in numerous budget proposals has championed changing the taxation of carried interest away from capital gains treatment to ordinary income.

The administration's fiscal year 2014 budget again called for taxing as ordinary income a partner's share of income on a so-called investment services partnership interest in an investment partnership, regardless of the character of the income at the partnership level (70 DTR GG-1, 4/11/13). As a result, such income would not be eligible for the reduced rates that apply to long-term capital gains. In addition, the proposal would require the partner to pay self-employment taxes on such income.

“By allowing service partners to receive capital gains treatment on labor income without limit, the current system creates an unfair and inefficient tax preference,” Obama's latest budget proposal said.

Fleischer said industry insiders are more tolerant of change so long as selling one's stake in a management company continues to receive capital gains tax treatment.

But not everyone in private equity appears ready to roll over, and they do not expect tax reform to advance without a so-called grand budget bargain, the prospects of which remain in doubt.

“Proposals offered by some policymakers to make long-term owners of companies ineligible for capital gains treatment would upend 100 years of tax policy that rewards entrepreneurial risk taking, hard work, and vision,” said Steve Judge, president and chief executive officer of Private Equity Growth Capital Council. “Given the 58 percent increase in taxes paid on capital gains as part of the recent deal to avert the fiscal cliff, it is our hope that any tax reform effort in 2013 will be about crafting policies that incentivize economic growth.”

Along those lines, Fleischer admitted that lobbyists could tamp back any perceived momentum, as they have helped to do in the past.

Close, but No Cigar in the Past

Three years ago, Senate Finance Committee Chairman Max Baucus (D-Mont.) fell three votes short of securing passage of compromise language that would have taxed 75 percent of carried interest at ordinary income tax rates. Investments held at least five years would have 50 percent of the carried interest income taxed at ordinary income tax rates.

Rosenthal acknowledged that in addition to finding a legislative vehicle, securing agreement on what might be a partial switch represents another obstacle, such as whether or not to recharacterize a piece of capital gains as ordinary, as Baucus did. Levin's legislation would change taxes on all carried interest income.

Baucus had put forth the legislation in June 2010 as an amendment to a House-passed extenders bill. The then Democratic-led House had voted 215-204 to pass a version of the bill that would tax 50 percent of carried interest at ordinary income tax rates until Jan. 1, 2013, at which point 75 percent of the interest would be taxed at that rate (103 DTR GG-1, 6/1/10).

Later on, in September 2010, Baucus introduced his 75 percent-25 percent compromise in a new bill (S. 3793), but it too did not advance. His proposal would have raised $13.6 billion over 10 years (185 DTR G-1, 9/27/10).

A year later, Baucus admitted in an interview that getting the provision passed would need to be done as part of a much bigger bill, though he was still hopeful for change.

In addition to Levin's forthcoming bill, his brother, Sen. Carl Levin (D-Mich.), has introduced carried interest legislation (S. 268) in this Congress. Among provisions in the bill, it would establish a rule to include gross income of partnership interests transferred in connection with performing services, and treat the net capital gain as ordinary income with respect to an investment services partnership interest, except to the extent such gain is attributable to a partner's qualified capital interest.

It would also exempt income from investment services partnership interests from treatment as qualifying income of a publicly traded partnership, increase penalties for underpaying taxes on income that would be treated as ordinary income, and trigger self-employment taxes.