For wealthy investment fund managers, the days of paying low taxes on high profits may be numbered. The deficit-fueled search for more revenue, along with political pressure to embrace “Main Street” over “Wall Street,” might be enough to raise taxes on the slice of investment profits that fund managers take home — so-called carried interest income.
Currently, managers of hedge funds, private equity and venture capital funds, and real estate partnerships treat their “carried interest” profits as long-term capital gains and pay a 15 percent tax on them, even though they must pay standard (and much higher) income tax rates on the 2 percent of the fund’s assets they receive annually as part of their compensation. Senate Democrats are near a deal to redefine how this income is taxed — though this approach is more generous to the fund managers than a provision included in the House bill which was passed on May 28. The change was included in a broad Senate bill extending unemployment benefits as a way to offset part of the measure's $140 billion cost.
Under the Senate plan, rolled out Tuesday in a substitute amendment to the bill offered by Senate Finance Committee chairman Max Baucus, 50 percent of investment fund managers’ carried interest gains would be taxed as regular income, while the remaining amount would be taxed at the lower capital gains rate between now and 2013. After that, 65 percent of the carried interest gains would be taxed at the regular income tax rate and the remaining 35 percent would be taxed at the lower rate.
The House bill calls for taxing 75 percent of carried interest profits at the higher income tax rate, which is scheduled to rise to 39.6 percent next year for top earners. Because the Senate version would raise less revenue than the House approach, Senate Democrats also proposed to increase taxes on oil produced offshore from 8 cents to 41 cents a barrel, to make up for the lost revenue.
to be taxed at the same rate as others who make millions and millions of dollars.”
The White House, some policy experts, and even some hedge fund industry lobbyists are readying themselves for the change. Hedge funds, which go largely unregulated, tend to take on the most risk for potentially high rewards. The top 25 hedge fund managers were paid a collective $25.3 billion in 2009 — about 20 percent in carried interest profit.
Two of the largest hedge funds, Citadel Investment Group and Bridgewater Associates, declined to comment for this story, and the hedge fund lobby, The Managed Funds Association, did not respond to phone calls. Though it’s safe to say they are less than thrilled with the proposed carried interest tax increases, they may be sliding towards acceptance as they focus their attention on their stake in the financial regulation bill, which the Senate passed on May 20.
“Fund managers can only fight so many battles at once, and I get the feeling this may be something they’ll have to swallow,” said Howard Gleckman, a senior research associate at the Urban Institute. “Private equity firms come out relatively well in the bank reregulation bill,” he said. Though the Senate bill requires hedge funds with $100 million or more in assets to register with the Securities and Exchange Commission for the first time, it could also push large investment banks to “spin off” their private equity units, leaving a golden opportunity for hedge funds to expand.
“In that environment I think they have to be very happy with the outcome, and don’t want to mess that up by going to their friends on Capitol Hill and saying, ‘Thanks for helping us out on that, but here’s one other thing we’d like you to do for us,'" Gleckman said.
The Pressure to Pass the Bill
If you invest your own money, any profit when assets are sold is taxed as capital gains instead of income, which usually means a lower tax rate. Right now, the same preferential tax treatment applies to the share of investment profits paid to investment fund managers, who invest other people’s money and are compensated in part based on those earnings.
“I think there does seem to be some understanding in the Senate that the country just can’t afford to be keeping this loophole open much longer,” said Michael Linden, associate director for tax and budget policy at the Center for American Progress. “I highly doubt senators are going to let a bill that extends tax breaks for small businesses and unemployment benefits go down over a tax loophole that only applies to a very small subset of the very wealthiest people in the country, who work on Wall Street no less.”
Closing that “tax loophole” would generate about $17 billion in tax revenue over the next 10 years, the Joint Committee on Taxation found. But any form of tax increase will be a tough sell for Senate Republicans, who argue that the added tax burden will trickle down to harm small partnerships and venture capital firms, discouraging them from investing in start-ups.
“At the end of the day, I think most of us understand the venture community will be paying more as a whole in taxes, but we want to make sure that you continue to incite people by keeping it a meaningful differential between ordinary income and capital gains,” said Mark Heesen, president of the National Venture Capital Association. A separate group of Democratic senators, joined by Republican Scott Brown, is pushing Baucus, D-Mont., to exempt venture capital firms from the tax hike.
“We believe that this change without proper protection for the venture capital industry could undermine the ability of small businesses to create jobs and get the economy back on track,” said Brown and Democrats Patty Murray of Washington, Bob Casey of Pennsylvania, Mark Warner of Virginia and Jeanne Shaheen of New Hampshire in a May 4 letter. “This change in policy could not occur at a worse time.”
Linden and Gleckman dispute that notion. “They are still going to make millions and millions of dollars. They are just going to be taxed at the same rate as others who make millions and millions of dollars," Linden said.