From the April 01, 2012 issue of Futures Magazine • Subscribe!

Carried interest, here we go again

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:

  1. The Romney ads mentioned earlier.
  2. 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.
  3. 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:

  1. 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. 
  2. 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.
  3. 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.

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