A change in the structure of the taxation of carried interest, passed by the House last December and included in the Obama administration budget for 2011, is becoming more likely as the Senate searches for revenue offsets.

The potential change, if enacted, would boost the tax on profits earned by hedge fund and private equity managers.

A “carried interest” is the right to receive a designated share of the profits of a partnership as compensation for managing or otherwise providing services to the partnership. It is considered part of the compensation for the managers, and is in addition to any investments they may have in the partnership.

As passed by the House, it would convert income derived from partnership-taxed entities to be taxed as ordinary income, rather than at the capital gains rate. The renewed interest in the Senate was evidenced by a remark last week by Senator Charles Schumer, D-N.Y., who said it was “on the table.” Previously, Schumer was against any such change.

“Originally, the carried interest provision was part of the extenders bill as a ‘pay for,’” said Stephen Breitstone, ab equity partner at Mineola, N.Y.-based Meltzer, Lippe, Goldstein & Breitstone, LLP.

“Then the Senate Finance Committee reached the conclusion that carried interest needs to be thought out more carefully. Perhaps some of the commentary worked its way up, they started to see problems, so several months ago it was still out of favor,” he said.

“But the alternative pay-for — black liquor — was tacked onto the health care package. [Black liquor, a byproduct of the papermaking process, was excluded from the cellulosic biofuel producer credit.] Since it’s no longer available to pay for extenders, they’re looking at carried interest again. What exactly they will come forward with is not yet clear because of all the technical problems.”

There are two possibilities, Breitstone suggested.

“One is to adopt a higher tax rate for gains on carried interest, but not denying capital gains treatment altogether,” he said. “The second possibility is to adopt a longer holding period. The idea is to target the short-term traders, the people who are not in for the long run.”

“The biggest fear is that they’ll dust off the version of the provision that was in the extenders package and tweak it and try to enact it in that form,” he said.

Among the unintended consequences would be to radically alter the landscape of real estate ventures and other venture capital partnerships, observed Breitstone.

“It changes natural law with regard to real estate partnerships,” he said. “In a typical transaction, one investor puts in money and someone else creates the deal. The people that create the deal are taking the bigger risks, since whatever capital they put in at an earlier stage before they bring in the outside investor is subordinated to the passive investors, and in exchange they get bigger backend participation.”

The carried interest rules would apply if you bring in investors as equity partners, he noted. “But if you go and borrow the money, they don’t apply, and you’re entitled to the capital gain treatment. This creates an incentive to go for the more highly leveraged capital structures, which is the opposite of what we should be doing,” he said.

John Volk, tax partner with Bay Area firm Sensiba San Filippo, noted that the legislation as presently drafted would change the character of a carried interest from capital gains to ordinary income, moving the tax rate from 15 percent to next year’s scheduled rate of 39.6 percent. “There would also be a self-employment tax add-on to that,” he said.

“From an overall perspective, these ventures have been awesome job creation vehicles in the U.S.,” said Volk. “Google, eBay, Amazon, Apple and Cisco were all founded or supported at the very front end substantially with venture capital investments.”

“One would hope that from an overall social policy perspective the job creation benefits would outweigh the chilling effect of a severe investment tax,” he added. “It’s hard to speculate how chilling that would be, but at the margin there would certainly be deals not done.”


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