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.