The Tax Man Cometh?

The convergence of hedge and private equity funds has been one of the most overplayed stories of the past few years, but the linkage seems to have beencemented in the minds of folks like Senator Chuck Grassley (R-IA). This isn’t to say that Grassley can’t distinguish between hedge and private equity (he can), but rather that his obsession with the former could eventually lead to misguided tax changes for the latter.

Grassley has spent a lot of wind-power trying to get hedge fund registration to sail, even introducing such an amendment earlier this week as part of an unrelated homeland security bill. “The secretive way that hedge funds operate might not be an issue for the super rich who first invested in hedge funds, but today the average Joe has a stake as pension funds are invested in hedge funds,” Grassley said Wednesday on the Senate floor. “Right now a hedge fund isn’t required to report even basic information about who runs the fund.”

Unfortunately, the amendment didn’t make muster, in part because Grassley doesn’t really have any authority over hedge funds. Not only is he now part of the Congressional minority, but he sits on the Senate Finance Committee instead of on the Senate Banking Committee. That latter group is chaired by Chris Dodd (D-CT), whose nutmeg state is the de facto home of hedge fund opulence (official mailing address is in the Caymans). Since all politics is local, Dodd has taken a laissez fair attitude toward any sort of hedge fund regulation – including registration.

But Grassley is one of those old-school conservatives who actually believes in pragmatic conservation (as opposed to dogmatic GOP groupthink). He is against increased taxes on the general populace, but also knows that the government needs to raise revenues to fund things like AMT relief and our various military entanglements. So he continues to look for what he considers to be tax loopholes (i.e., don’t raise taxes, just strengthen existing law).

As Grassley’s search has progressed, the hedge fund/private equity convergence drumbeat has only grown louder. Not coincidentally, Grassley’s tax loophole search has broadened to also consider private equity.And it is in here that Grassley – or at least his staffers — believes he might have found such a loophole: The categorization of carried interest as capital gains.

Carried interest is the 20%-30% capital slice that private equity firms keep after selling portfolio company positions at a profit. Since such gains are completely based on long-term investment success, they have traditionally been classified as capital gains and therefore taxed at 15 percent. But Grassley and his staffers apparently are floating a notion that they should instead be considered compensation for services, and therefore taxed at income rates closer to 35%. This would be a huge change not just from an accounting perspective, but also from a take-home pay perspective. After all, it would be more than a doubling of taxation on PE firm profits.

Now you and I are free to think this is sophomoric. Raising government revenue is indeed necessary, but it should be done via honest tax increases and reduced pork (and a reduced war). Don’t pretend that carried interest as capital gains is a tax loophole. It isn’t. Carried interest is generated by profitable investment, and is not at all guaranteed at the time of initial disbursement. I’m not saying Congress doesn’t have the right to change the classification (it does), but rather that it would be disingenuous to do so without a wholesale change in the definition of capital gains.

It is important to emphasize that there is no pending legislation on this matter, but enough rumors have been swirling that at least two separate law firms have issued client alerts. It also has prompted the first public comment from the newly-formed Private Equity Council, and yesterday the National Venture Capital Association sent out its own members alert (saying not to worry… yet). Finally, there is a semi-strong counterargument that GPs put very little of their own skin into funds – and in some cases even offset any commitments altogether by waiving management fees – so what appear to be capital gains are indeed more accurately described as income. I’ll keep thinking about this while lounging around Kennebunkport over the next two days (birthday present from J), and encourage your comments…