A US Chamber of Commerce study predicts dire consequences if a proposed carried interest tax increase passes in the Congress. But one private equity CFO speaking to Private Funds CFO reacted with a shrug to the proposal.
In a report released September 7 by the Chamber’s Center for Capital Markets Competitiveness, titled Impact On Jobs, Tax Revenue and Economic Growth of Proposed Tax Increase on Carried Interest, Charles Swenson, accounting professor at the University of Southern California, detailed how a proposed 98 percent tax increase on capital gains would reduce investment, lead to widespread job losses and decrease federal, state and local tax revenue.
At the time of writing, the House Ways and Means Committee moved to mitigate the perceived disastrous consequences of the Biden administration’s American Families Plan on carried interest, and of a Senate bill to close the carried interest tax ‘loophole’ floated in August, by proposing that the current three-year holding period to qualify for capital gains tax is extended to five years. Progressive Democrats were lobbying for more stringent rules as Private Funds CFO went to press, and elements of the Senate bill could still find their way into final legislation.
The American Families Plan, part of the 2022 federal budget, proposes treating carried interest as ordinary income tax for those who make more than $400,000 per year starting in 2022.
Swenson noted in the report that the resulting downsizing seemed to be “at odds with the policy objectives of the [Biden administration’s] Build Back Better agenda, including investment in renewables and infrastructure, assisting with covid-19 recovery and promoting job creation.”
What the Senate wants
The proposal from the Senate, the “Ending the Carried Interest Loophole Act,” comes at carried interest differently. Introduced on August 5, the bill “would likely have a significant impact on carried interest partners” if enacted, concluded Jeff Bilsky, partner, national technical practice leader, partnership taxation at BDO, and co-author Neal Weber, managing director, national partnership taxation at BDO’s Atlanta office, in an August tax newsletter. Elements of that bill could still end up in the final legislation. Whatever form the House Ways and Means Committee’s final version takes, it will go to the House where, if passed, it would go to the Senate.
The Senate’s bill treats a taxpayer’s “applicable partnership interest” as ordinary income, subject to income and self-employment taxes upon each partner’s deemed compensation.
Based on the definitions contained in the bill, the newsletter continued, “The effect of the proposal appears to be the acceleration of ordinary taxable income, regardless of whether there has been an actual disposition event, with a capital loss that may be available to offset future capital gain allocations resulting from the actual dispositions of portfolio investments.”
Such deemed compensation would be equal to a percentage of increases in fund-invested assets multiplied by the carried interest partners’ highest profit allocation percentage, BDO says. The percentage of taxable gain on fund assets used in the calculations would be equal to the par yield for a five-year high-quality corporate bond, plus 9 percentage points.
The BDO newsletter explained how it would work: Suppose a newly formed fund has $100 million of invested capital at the end of the calendar year 2022, and the fund manager is entitled to a maximum carried interest allocation equal to 20 percent of the fund gain. Assuming the five-year corporate bond yield is 3 percent, the resulting percentage of fund assets to be used in determining the deemed compensation would be 12 percent.
Based on these facts, the fund manager would report $2.4 million in deemed compensation for 2022, with a corresponding $2.4 million capital loss. Suppose also that by year-end 2023, the fund-invested capital had increased to $150 million. The fund manager would have to recognize an additional $1.2 million in deemed compensation for 2023, with a corresponding capital loss.
BDO advises clients to closely follow developments to consider taking “steps to mitigate the impact” of these rules should they become law.
Swenson estimated in the report that, if enacted, the proposed carried interest tax would in five years eliminate 4.9 million jobs across the US. By year five, federal, state and local tax revenues could drop by $96 billion annually. Worse, pension funds could lose up to $3 billion annually, resulting in lost retirement earnings and pension fund losses that state and local governments may be forced to scramble to make up for.
The report noted that the three industries most affected by the increased tax charges on carried interest are private equity, venture capital and real estate. These firms, with their portfolio companies, are responsible for 25 million American jobs and over $493 billion in estimated annual federal state and local tax revenues, according to the report.
At the industry level, private equity would be hit hardest by the tax increase, the report projected. Private fund firms would lose 3.15 million jobs, and $58.5 billion contributed to federal, state and local tax revenues. Real estate firms would lose 1.8 million jobs and $38 billion in combined tax revenue, the report estimated.
The report notes that the current proposed tax change would be “so impactful” that it would eliminate more than 3 percent of the country’s workforce. Applying “standard economic theory,” the report predicts an up to 19.55 percent downsizing of the private equity, venture capital and taxable partnership-based real estate industries, with failures of many PE and venture-backed firms. The tax increases would also act as a disincentive both in the labor force and in capital formation, the report concluded.
But the increase under the proposed rules may not be as drastic as some people believe. Washington’s tax hawks have already tightened the screws. Last year, the 2017 Tax Cuts and Jobs Act changed the rules to allow for carried interest to be taxed as capital gains only if an asset is held for more than three years. Failure to hold the investment for more than three years now results in the carried interest gain allocation being recharacterized at much more onerous short-term rates.
Whatever the final result, expect creative responses from the PE industry if the proposals do become law, says one PE pro. “There may be an impact, as the industry transitions, but not as extreme as the predictions in the US Chamber of Commerce Report,” said a New York PE financial officer, who asked not to be named, of the American Families Plan as originally proposed. “What’s the alternative? It’s not as if they are going to take down their shingles.”
Besides, the largest private equity firms have plenty of options at their disposal. They can pass the increase on to clients, change tax jurisdictions or even move more business to states without income tax. “There’s just too much institutional money invested in this PE industry to expect people to close shop,” he added.
Asked about the Senate bill, which when proposed in August was seen as the most severe proposal threatening carried interest, Monte Jackel, counsel for M&A consulting firm Leo Berwick, shrugged. “Ultimately there’s not going to be much done,” Jackel said.