The Senate has scaled back some of thehikes in the tax treatment of carried interest in the tax extenders andunemployment bill after intense lobbying by private equity firms, hedge funds,venture capital firms and real estate investment partnerships.

Carried interest has generally been taxed at only the 15percent capital gains tax rate, as opposed to the ordinary income tax rate ofup to 35 percent, providing a boon to the partners in investment firms such ashedge funds and private equity partnerships. To offset the expense of thevarious tax extenders and unemployment benefit extensions of the bill, thelegislation had originally proposed to change that treatment and raise over$18.685 billion in revenue in 10 years. To the extent that carried interestreflects a return on invested capital, the original version of the bill wouldcontinue to tax carried interest at capital gain tax rates. However, to theextent that carried interest does not reflect a return on invested capital, thebill would require investment fund managers to treat 75 percent of theremaining carried interest as ordinary income (50 percent for taxable yearsbeginning before Jan. 1, 2013).

In a substitute amendment to the American Jobs andClosing Tax Loopholes Act of 2010, the Senate decreased the amount of carriedinterest that would be re-characterized as ordinary income from 75 percent to65 percent and increase the amount treated as capital gains from 25 percent to35 percent in taxable years beginning after Dec. 12, 2012. The change furtherdecreases the amount of carried interest that is re-characterized as ordinaryincome to 55 percent and increases the amount treated as capital gains to 45percent for a gain or loss attributable to the sale of an asset which is heldfor seven or more years.

Another modification provides that a non-serviceindividual or widely held regulated investment company who sells an interest(held directly or indirectly through a partnership, S corporation, estate, ortrust) in an energy-related publicly traded partnership would be exempt fromrecharacterizing as ordinary income that portion of the gain or lossattributable to investment services partnership interests held by the publiclytraded partnership under Section 751(a) of the Tax Code.

With these modifications, the carried interest provisionis now estimated to raise $14.453 billion over 10 years, instead of the morethan $18 billion originally estimated.

The House passed a version of the bill last monthcontaining the original carried interest provision.

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