Once again, Rep. Sandy Levin (D-MI), a senior member of the House Ways and Means Committee, working with President Obama, has proposed a bill to end the perceived tax benefits of carried interest. On Feb. 14, Levin introduced the “Carried Interest Fairness Act of 2012,” which would tax any carried interest received as ordinary income, subjecting it to self-employment taxes. This is the third direct attempt by Levin to restrict carried interest since he first introduced legislation on this topic in 2007, not to mention the multiple times this concept had been included in other pieces of legislation since his initial 2007 bill.
Just a couple of months back, the notion that this bill would have any chance of making it through the Republican-controlled House was laughable, but that may not be the case now. As the Republican primaries heated up, attacks from within the ranks on Mitt Romney’s tax returns and the tax benefits afforded him by carried interest as a private equity manager may have put the issue back in play. This time, to pressure members of the Republican Party to vote for his bill, Levin need only re-run the Republican-made ads attacking Mitt Romney’s taxes that ran during those primary elections.
A carried interest (often referred to as an incentive or profit allocation) is the percentage of the profit of an investment partnership that is allocated to Commodity Pool Operators (CPOs), Commodity Trading Advisers (CTAs), hedge fund, private-equity, real estate and venture capital managers, not taking into account any investment such manager has made in the respective investment partnership. As a participant in the partnership, a fund manager will receive a portion of their clients’ earnings as an allocation of the investment income made in the partnership. The following discussion addresses the impact the proposed legislation would have if it were to become law on CPOs and CTAs, referring to them collectively as “fund manager(s),” who manage commodity pool investment partnerships.
A fund manager earning carried interest from a commodity pool does enjoy a benefit, in most cases, of such income being subject to reduced capital gain tax rates as compared to ordinary income tax rates under the current tax law. How it works is that, as a partner, the fund manager is allocated a set percentage of the gains earned in the commodity pool. These gains retain the tax character of the types of income earned by the commodity pool.
The best way to show how taxes on the carried interest work is to give some examples. For purposes of these examples, assume the fund manager only trades contracts considered Regulated Futures Contracts that are subject to taxation under the Internal Revenue Code Section 1256 (“Section 1256 contracts”). Gains from Section 1256 contracts by statute are taxed as 60% long-term capital gain and 40% short-term capital gain and are marked-to-market, as if sold, at year end. Some non-U.S. futures contracts approved for trading in the United States are not subject to Section 1256 and do not receive the favorable tax treatment.
In both of our examples we assume the fund manager earns a $1 million carried interest allocation comprised of all Section 1256 contract gains, and is considered to be in the current highest individual ordinary income tax bracket already, which is 35% for 2012 (see “What you pay today” and “What you could pay tomorrow,” next page).
As you can see in the following examples, the effect of taxing $1 million of carried interest at ordinary tax rates under the Levin proposal for a fund manager equates to a hefty tax increase of $143,925, or 62.6%, as compared to current law.
Will this third iteration of the Levin carried interest legislation become law? Possibly. A few reasons why it might are:
- The Romney ads mentioned earlier.
- The current bill left out a truly punitive tax provision called the Enterprise tax. Under this tax, if a fund manager were to sell the management company, the Enterprise tax would have catagorized any gain on the sale as ordinary income and not capital gain. If the Enterprise tax provision were included again, then that would guarantee the bill would be dead in the water in the Republican-controlled House. However, with that provision removed, the thought is that there is a greater chance to pressure certain Republicans to vote for the legislation in both the House and the Senate.
- Given the size of projected budget deficits, the fact is that both Republicans and Democrats want to pass a group of tax extenders that have expired, and there is continuing pressure for Congress to find revenue for new initiatives. The bottom line is the government is looking for revenue, and getting it from perceived rich hedge funds would be one of the least objectionable sources.
On the flip side, a few significant reasons that may help keep this bill from becoming law are:
- The bill still contains a provision that possibly could cause a whipsaw tax effect to a fund manager and this is unarguably onerous. Net losses allocated to the fund manager would be deferred until income is allocated or the interest is sold or liquidated. While these real losses currently are not allowed to be taken, the fund manager still would be required to pick up management fees as ordinary income. In addition, if the fund manager sells its interest while it still has these deferred losses, this could result in these losses being re-characterized as capital losses.
- Compared to many other revenue-raising initiatives, the $13.5 billion over 10 years that is projected to be earned by this bill is not overly significant, especially when taking into account the fight that has gone on in relation to all the previous iterations of this legislation.
- Republicans in general want to use spending cuts to raise revenue as opposed to creating new taxes.
Several industry groups, have been educating/lobbying Congress on the merits of carried interest as it is treated currently. One such argument is that carried interest is not guaranteed salary income to a fund manager. Management fees for services received by the fund manager already are taxed as ordinary income. A carried interest cannot even be valued at the time it is granted because its allocation is contingent upon the ultimate profitability of the commodity pool.
At the same time, other groups, including the Ways & Means Committee Democratic staff, have given their reasons why carried interest should be taxed as ordinary income, in a background document on the legislation and in other literature titled “Myths vs. Facts.” In the latter they argue against the claim that taxing carried interest as ordinary income would harm investors, calling it a matter of fairness. They also argue that “carried interest really represents a performance-based fee that investors are paying to fund managers and that it should be taxed accordingly.”
This is an election year and that could have an impact on someone’s vote. Exactly what that impact will be, we will have to wait and see. But chances are we’ll be saying, “Here we go again” next year.
What you pay today
Under current tax law the fund manager earning $1 million would pay $230,000 in income taxes on the carried interest under the current law (an effective tax rate of 23%). This is calculated in two steps. As mentioned, Section 1256 contracts are taxed as 60% long-term capital gain and 40% short-term capital gain and are treated as if sold at year end. So, first multiply the $1 million by 60% and then by the long-term capital gain rate of 15%, which equals $90,000. Second, multiply the $1 million by 40% and then by the highest marginal tax rate for short-term capital gains of 35%, which equals $140,000. Those two amounts together equal $230,000 in taxes on the $1 million carried interest earned.
What you could pay tomorrow
If the proposal to tax carried interest as ordinary income becomes law, the fund manager earning $1 million could pay $373,925 in income taxes on the carried interest (an effective tax rate of 37.4%). This actually is calculated in several steps; however, we will summarize it in two. First, multiply the $1 million by the 35% ordinary income marginal tax rate, which equals $350,000. Second, because this income is now subject to self-employment taxes we must calculate both the employer and employee portions of FICA/Social Security and Medicare taxes. We do make an assumption that the fund manager already does have enough earned income from other sources to be above the FICA tax threshold so therefore only the Medicare tax will be calculated on the carried interest. The net effective tax rate for self-employment Medicare taxes on $1 million is 2.4%, which equals $23,925. Under this latest Levin proposal, the fund manager would pay $373,925 in income taxes on the carried interest for an effective tax rate of 37.4%.
Robert Hartnett, CPA, is a tax principal with Rothstein Kass. He specializes in providing tax planning, consulting and compliance services to a wide variety of investment fund clients.