As Washington grapples with the country’s fiscal woes, the private equity industry is grudgingly facing a new reality: Its long-held tax advantages are likely to disappear.
For years, private equity has quashed efforts to raise taxes on carried interest income, the profits partners receive as part of their compensation. Those earnings are considered capital gains, so they are taxed at a much lower rate than ordinary income.
While few concede defeat publicly, the industry is rethinking its strategy. Rather than trying to stop the changes outright, lawyers and executives behind the scenes are trying to minimize the hit if it happens.
Private equity recognizes the shifting politics. In the current budget debate, sacred cows like the tax deductions for home mortgage interest and charitable donations are on the table, along with potential cuts to Social Security and Medicare.
“Once they start looking for revenues, carried interest will be on the list,” said Anne Mathias, director of Washington policy research at Guggenheim Partners, a financial services firm. “You can hear it already: ‘We need that money, or Grandma won’t get a new hip.”’
Democrats and Republicans alike are looking at eliminating loopholes as part of a broader effort to overhaul the tax code. Changes to the treatment of carried interest could bring in $17 billion over 10 years, according to congressional estimates.
“There is absolutely no reason why income earned for managing other people’s money shouldn’t be taxed in the same way as income earned teaching or working in a factory,” said Rep. Sander Levin, D-Mich., who introduced the latest carried interest bill in 2012. Legislation based on Levin’s bill is likely to be part of a broader package if carried interest comes into play.
Officially, the private equity industry remains opposed to change. Its lobbying group, the Private Equity Growth Capital Council, began an extensive public relations campaign last year to improve the industry’s image during the presidential race, in which the GOP candidate, Mitt Romney, was criticized for his actions as chief executive of the private equity firm Bain Capital.
But even as the industry continues to press its case, many of its members acknowledge that the carried interest break is coming to an end.
“At some point it’s inevitable, so they will deal with it,” said Bradley Morrow, a senior private markets consultant at Towers Watson.
If the proposal does re-emerge, the industry is expected to focus its lobbying on softening transition rules.
One issue will be the amount of carried interest reclassified as ordinary income. Levin’s 2012 bill would convert 100 percent of carried interest. By contrast, an earlier version of the bill proposed capping the affected income at 50-75 percent.
The industry is also likely to focus on how quickly any changes would go into effect. Lobbyists will probably push for a longer delay, even if it means little or no cap, said Micah Bloomfield, a tax lawyer with Stroock & Stroock & Lavan. That would give partners more time to pocket capital gains or restructure funds before the rate increase took effect.
Another point of contention will be the treatment of profits partners earn when they sell stakes in their firms, a sum known as enterprise value. Currently, profits attributable to enterprise value are treated as capital gains. In earlier bills, they would have been reclassified as ordinary income.
“What people complained most vociferously about in the earlier bills was the treatment of enterprise value,” said James Brown, a tax lawyer with Willkie Farr & Gallagher.