Is Congress Going to Soak Private Equity with Taxes?

Based on an analysis of the Tax Policy Center, the federal government will need to raise $500 billion per year to reduce the budget deficit to roughly 3% of the gross domestic product. So Congress is looking at various ways to raise taxes without causing much angst.

As should be no surprise, one promising target is the wealthy group of private equity managers. They have benefited nicely from a tax loophole and have been quite effective in keeping it intact (millions of dollars in lobbying may have something to with that). For the past three years, proposed tax changes have not passed muster with the Senate.

But things may be changing. New York Senator Charles Schumer has said that the House tax proposal is on the table. If it gets approval, it could mean $24.6 billion in tax revenues over the next decade.

Carried Interest Got Carried Away?

If you look at the Forbes list of wealthy Americans, you will notice a variety are managers of private equity firms and hedge funds. Examples include George Soros ($13 billion), James Simons ($8.5 billion), John Paulson ($6.8 billion), the Blackstone Group's (BX) Stephen Schwarzman ($4.7 billion) and KKR's Henry Kravis ($3.8 billion).

The general compensation structure of hedge funds allows for massive paydays. A fund will typically get 1.5% to 2% of the assets under management as a management fee. Next, there is a 20% to 25% take of the profits, which is known as the carried interest.

The management fee is taxed as ordinary income, which has a top rate of 35% (this will probably go to 39.6% next year). However, the carried interest is taxed as a capital gain or a maximum of 15% (the rate is likely to go to 20% next year). This is the case even though a fund manager may have only put up a minimal amount of capital.

Like many loopholes, the tax on carried interest was not meant for private equity. After all, Congress legislated this in 1954, when such funds did not exist. Instead, the tax break was meant small partnerships.

Yet, if you look at the private equity industry, the funds are far from small and often manage billions of dollars.

Stifle an Industry?

All taxes have an impact. The question is: how much?

In the case of an increase on the carried interest, this would not impact the investors in private equity funds. Basically, it is the managers that will need to write bigger checks to the IRS.

And if you are making millions -- or even billions -- from managing a private equity fund, are you really going to change your profession because your taxes have gone from 15% to 39.6%? Probably not.

One counter argument is that the tax on carried interest will have a negative impact on venture capital investments. But again, if a fund manager cannot run a successful business because because he or she cannot pay a 39.6% tax on his earnings, maybe he should do something else for a living, right?

Given the budget pressures and high level of unemployment, it seems politically safe to soak private equity managers with taxes. If anything, it would be bringing taxes up to the levels that the rest of us pay when we earn income -- which doesn't seem to be unreasonable.