Baucus: No Tax Increase (Yet)

If there’s one thing that keeps private equiteers up at night, you’d think it would be the prospect of a debt market collapse. But judging by some recent cocktail party kibitzing, the real worry is that federal lawmakers will change their tax treatment of carried interest from capital gains to ordinary income. Oh the horror of being filthy rich instead of obscenely rich…

Much of this consternation has been prompted by the combination of a Democratic Party majority with a bipartisan mandate to increase federal revenue. Today, however, Senate Finance Committee chief Max Baucus (D-MO) offered a paper bag to hyperventilating investors, by telling the National Press Club that his committee is “nowhere close” to drafting such legislation. Or, as Baucus put it: “People need to keep their shirts on here.”

Before continuing, it’s worth noting that the National Venture Capital Association has contributed $10,500 to Baucus since 2001. Consider yourself disclaimed.

Baucus is certainly correct that tax change speculation has far outpaced senatorial examination, in part because private equity is still considered quite opaque to those on the outside (I like to think I straddle the fence). But I’d be stunned if something doesn’t happen in this area. Probably not a full switch from capital gains to carried interest, but rather a hybrid approach whereby: (a) Profits derived from general partner commitments will continue to receive capital gain status; (b) Remaining profits will be taxed as ordinary income.

After all, why should a general partnership receive capital gain benefits from returns on someone else’s capital? Moreover, let me repeat the point about the federal government’s urgent need to raise revenue. Some very sloppy back-of-the-envelope math shows that a hybrid tax treatment change could generate in excess of $7 billion. In pragmatic terms, that’s nearly enough to fund the Iraq War for an entire month.

Oh, but there’s one major caveat to the above pragmatism. Those private equiteers are not just sweating while awake at night. They’re also devising ways to restructure their firms/funds if such a change comes to pass. I don’t know how they’ll do it – but suffice to say that more than a few PE attorneys are already trying to figure it out.