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Are The Days Numbered for Carried-Interest Tax Treatment?

Latest Proposals For Higher Taxation of Investment Income Tied to Sequestration Debate
February 20, 2013
The latest salvo in the battle over the tax treatment of carried-interest investment income earned by partnerships, real estate funds, hedge fund and other investment entities has officially been fired.

U.S. Sen. Carl Levin (D-MI) has reintroduced legislation supported by the administration and congressional Democrats to classify carried-interest investment income as ordinary income for tax-reporting purposes, a move vehemently opposed by the real estate industry and other business and investment groups.

As in past versions, the "Cut Unjustified Tax Loopholes Act" submitted by Levin on Feb. 12 would raise taxes on the carried interest income of investment partnerships from the capital gains investments rate, which jumps from 15% to as high as 20% this year, to the ordinary income tax rate, which rises from 35% to a high of 39.6%.

Carried interest income represents a portion of the future profits of an investment partnership and is paid to general partners as incentive compensation. Used for decades as an investment model in commercial real estate, the carried interest is paid to general partners in a real estate venture, often after many years, in exchange for "sweat equity and substantial risks taken during development and sale of the project," according to Real Estate Roundtable, a real estate trade group. Such assumed risks by investors include debt liability, environmental contamination, operational shortfalls, construction delays and lawsuits.

"While deficit reduction is a pressing national concern, progress on this policy goal must not come at the expense of job creation, entrepreneurship, and investment. It must also avoid targeting select industries. Yet, that is exactly what would happen if all carried interest were now treated as ordinary income, even if actually from a capital asset, for tax purposes," the Roundtable declared in its newly issued policy statement on the topic.

"Given the consequences of changing 30-40 years of partnership carried interest taxation, this issue is too important to simply be another revenue-raiser addressing short-term budget goals," the real estate group said in its policy statement, and urged any proposals to re-characterize income be discussed in the context of fundamental tax reform and partnership tax law relating to all business activities, not primarily just real estate.

Along with changing the current tax treatment of carried interests, Levin’s bill seeks to address tax haven income, promotion of tax shelters and deductions for stock options, among other provisions.

Levin is chairman of the Senate permanent investigations subcommittee looking into the taxation of offshore income. The Michigan Democrat said he wants to attach the bill to Senate legislation averting sequestration -- severe cuts in federal spending set to begin in March.

"Corporations today pay an average tax rate of just 12%," Levin said in a floor statement. "How is that possible, when the statutory tax rate on corporations is 35%? Through loopholes in the tax code."

Levin said his legislation co-authored with Sen. Sheldon Whitehouse (D-RI) would also "close the carried-interest loophole, which allows hedge fund managers to pay a lower capital gains rate on the compensation they receive for managing money, while everyone else must pay the higher ordinary income tax rate on pay for the work they do."

Bernie Sanders, I-Vt., this month also introduced separate legislation that would end the ability of U.S. companies to defer taxes on offshore income, among other international tax changes.

Although the House leadership, including Speaker John Boehner, R-Ohio, and House Ways and Means Chairman Dave Camp, R-MI, have rejected proposals by Democrats to replace sequestration with tax increases, saying it should only be replaced only through spending cuts and comprehensive tax reform, political observers see the controversial carried-interest provision as a likely target for any significant tax reform legislation.

Gregory Valliere, chief political strategist for Washington, D.C.-based Potomac Research Group, which advises institutional investors on legislative and political issues, told more than 700 Colliers International brokers and clients at the firm's annual conference last week that, while he doesn’t anticipate another major effort to raise taxes by Congress, he said he can’t rule out another effort to revisit carried-interest taxation.

"I’m surprised carried interest has prevailed for as long as it has," said Valliere, speaking at Trends2013, Colliers International’s annual commercial real estate forecast, held in San Jose, CA, adding, "there may be an attempt to take a little haircut for the oil and gas companies," which frequently structure themselves as carried-interest partnerships.

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