Split the Baby?

peHUB has learned that some Democratic lawmakers are talking compromise on the carried interest tax kerfuffle. The only problem is that they would be compromising with themselves, while the GOP remains entrenched at Fort Status Quo.

To date, the issue has boiled down to this fundamental question: Should carried interest be treated by the IRS as capital gains or as ordinary income?

In response, most people have felt compelled to pick sides. For example, the leading Republican presidential candidates have all expressed support for the current capital gains treatment, while their Democratic rivals are in favor of a change to ordinary income. Here at peHUB, I’ve written that ordinary income is more applicable, while my colleague Alex Haislip has argued forcefully for the maintenance of present policy. I also expect some divergence when discussing the issue later today at the Private Equity CFO Conference in Redwood City.

But what if all of us were wrong to pick sides? What if carried interest has significant characteristics of both capital gains and ordinary income – and, conversely, significant character flaws in both regards? What if it is really an amalgam of the two, and our real debate is over percentages rather than over absolute values?

That’s where the aforementioned compromise comes in. I’m told that certain Democratic lawmakers are borrowing from something known as the 60/40 rule, which was originally designed to dissuade futures traders from engaging in tax arbitrage. In short, it says that gains made on securities like futures contracts are treated as a weighted combination of long-term (60%) and short-term (40%) gains – no matter how long the security was actually held.

The idea is to apply the 60/40 rule to carried interest. For example, perhaps 60% of carried interest would remain taxed as capital gains, while the other 40% would be taxed as ordinary income. Or maybe you play with the percentages, and end up with a 55/45 rule. Either way, it would be a recognition that carried interest has inherent elements of both tax treatments.

The net result, of course, would be a tax increase. Smaller than what’s currently proposed in the Levin bill, but still more than what is currently on the books. At 60/40, it would work out to around 27 percent.

Not a bad idea from my point of view, but this is where political reality is likely to trump tax theology. Most Republicans are dead-set against any sort of tax increase on carried interest, because they view it as an opening salvo against the 15% capital gains rate (for everyone). As one private equity lobbyist explained to me: “The question to ask is: ‘Would Grover Norquist support it?’ It’s not quite that simple, but it’s also not that far off base.”

To be clear, Grover Norquist would oppose the 60/40 compromise.

Another lobbyist said that such a solution could perhaps siphon off a few Republican senators – in addition to existing Finance Committee defectors Chuck Grassley and (maybe) Olympia Snowe – but not nearly enough to overcome an expected presidential veto. For the most part, there is GOP solidarity.

Democratic senators, on the other hand, are all over the map. More specifically, the map is helping to “inform” their position. Chuck Schumer from the Wall Street State, for example, has expressed doubts about the pending legislation – as has John Kerry from VC-heavy Massachusetts. Even Harry Reid of Nevada has said that he is unlikely to bring any carried interest legislation to the floor this year. After all, wouldn’t want to scuttle the next Harrah’s deal…

What all this means is that the Democratic compromise is really an effort to get its own caucus back in line – so that it can use this issue as a marker next November. Very few folks outside the financial and political beltway have even given a passing thought to carried interest, but the basic Democratic sound bite – “Why should billionaires pay 15% taxes on their income” — would be a clear winner…

At least at the ballot box. In terms of legislation, it is beginning to look dead on arrival.