Losing the battle against higher carry tax

With unstable market conditions and the possibility that the US could default on its debt, protecting current carried interest tax rates is not on the top of Washington’s priority list.

Many industry players were sure the momentum in the US for a carried interest tax increase died last year when business-friendly Republicans took control of the US Congress. Not so. Republicans are now being forced to make difficult decisions during ongoing debt ceiling negotiations, and US GPs should get ready to open their wallet a little wider as a result.

Congress and President Barack Obama have been locked in a bitter battle surrounding raising the debt ceiling, with various tax increases expected to be part of the final agreement.

In April, Obama unveiled his budget proposal, which directed Congress to require executives of private equity firms to pay ordinary income tax rates as high as 35 percent (39.6 percent after 2012) on the profits they receive as compensation. Carried interest currently qualifies for lower capital gains tax rates of 15 percent (20 percent after 2012).

Debate over carried interest tax designation has raged over the past few years with Republicans defending the capital gains rate and Democrats arguing a carried interest tax hike could help address the deficit. In 2009, the government estimated that taxing carry as ordinary income would raise nearly $26 billion in tax revenue. While that would be a drop in the bucket in terms of paying down the $14 trillion national debt, Congress remains under intense pressure to increase revenue by all means necessary.

“The debt ceiling has to be raised by August 2nd and a deal must be done,” said a New York-based lawyer. “Carried interest is one of many tax negotiations, but word is that Republicans don’t think it’s an issue that’s worth fighting for.”

Meanwhile, there has been a last minute effort against a carried interest tax hike from an unlikely pair, two Democrats. Last week, US House of Representatives members Jared Polis and Mike Quigley sent a letter to President Obama strongly opposing a tax increase on carried interest. Polis and Quigley argued that while some members of Congress try to characterise a tax increase on carried interest as merely closing a loophole, the tax code provision was created to encourage long-term investment and job creation. However, some Washington insiders say the Polis and Quigley letter was a calculated political gesture trying to win broader appeal for re-election.

“The larger picture,” says one source, “is that lawyers are preparing clients for a change in tax law.”