Carry Tax Debate Alive in Senate, Too

The Congressional debate over tax treatment of carried interest – a topic much of the private equity industry thought (and hoped) had petered out over the summer – is poised for revival in the Senate as well as in the House.

Starting in September, the Senate Finance Committee plans to begin tackling the issue of whether the distributions of profits private equity managers make on their investments should be taxed as capital gains or compensation, according to Russ Sullivan, the committee’s Democratic staff director.

Sullivan, a staffer for Montana Senator and Finance Committee Chairman Max Baucus, said he expects the committee will study the issue for several months and will reach one of three possible outcomes. The first, in alignment with the bill proposed by Rep. Levin (D-MI) in the House, in late June, would be to change the tax treatment of carried interest from capital gains, taxed at a long-term rate of 15%, to ordinary income, which tops out at 35%. It would apply to all “investment management firms,” such as VC funds, mezzanine funds, growth equity funds buyout funds, hedge funds and real estate funds.

A second option would be to leave current tax treatment in place, treating carried interest as capital gains.

A third possibility would involve providing varying tax treatment depending on the manner in which carried it interest is distributed.

To enable this sort of split, policymakers would need to draft guidelines for when carried interest ought to be taxed as compensation and when it ought to be taxed as income.

Passage of any change in carried interest taxation will also depend on the other legislation with which such a proposal is paired, Sullivan said. For example, if a proposed carry tax change was paired with a bill extending relief from the Alternative Minimum Tax – a popular cause in the Senate – it would be more likely to pass.

Sullivan didn’t express an opinion regarding which form of tax treatment carried interest from venture capital funds ought to receive. However, several conference attendees urged lawmakers to continue taxing venture carry at the capital gains rate, citing the volatility of returns in the sector.

“It’s not like getting a bonus from GE,” said Robert Grady, head of Carlyle Venture Partners. “It is an investment of risk.”

Grady cited data from research firm Cambridge Associates showing that over the last 11 years, the median venture fund returned -5%. In testimony before the Senate Finance Committee in July, National Venture Capital Associate Board Member Kate Mitchell argued that carried interest paid to venture capitalists has always been consistent with capital gains tax philosophy and should continue to be recognized as such.

Currently, there is no companion bill in the Senate to the House bill on carry tax proposed by Rep. Sander Levin (D-MI). However, a bill proposed by Sen. Baucus, S.1624, also stands to impact the private equity industry. The bill proposes to treat publicly traded partnerships that make money from providing investment advice or asset management services as corporations for income tax purposes. That bill, in its current form, would not directly impact private venture capital firms. However, it would affect publicly traded buyout investors, such as Blackstone Group and others who have sold public stakes or are considering doing so.

The Private Equity Council and other industry groups have opposed the Baucus bill, arguing that it would discourage U.S. private equity firms from offering shares to the public and in the process undermine U.S. financial competitiveness.