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Commentary By Diana Furchtgott-Roth

The Danger of High Taxes On Carried Interest

Economics, Economics Tax & Budget

Buried in the tax extenders bill that will be up for a vote in the Senate next week, after passing the House on May 28, are provisions altering the current capital gains treatment of profits earned by real estate, venture capital, private equity and other investment partnerships. The bills would change the tax treatment of some partnership profits, known as “carried interest,” and would increase taxes on the “enterprise value” - goodwill, the brand value of a company over and above the value of its physical plant and equipment and receivables - that entrepreneurs create in these businesses when the time comes to sell their ownership stakes, making these firms less valuable.

This is yet another step in making America less attractive to innovators and entrepreneurs. Firms would make fewer investments, especially in the businesses or projects that most need capital. That, in turn, would further reduce economic activity, especially financing for private companies, innovators, and small firms getting off the ground. And because this bill would put U.S. investment partnerships at a disadvantage relative to their international counterparts, some of this investment capital over time is likely to move offshore. Private equity assets under management now total $2.3 trillion, of which $1.2 trillion is invested capital and $1.1 trillion is callable capital reserves. That’s a substantial sum.

“Carried interest” is a net profit share - often in the range of 20% - received by general partners on the sale of a capital asset, whether it’s a shopping center or a company. The remainder of the net profit is distributed among limited partners, generally public and corporate pension funds, charitable foundations, endowments, individuals, and other equity funds.

Currently, carried interest resulting from long-term capital gains in a partnership is taxed at a long-term capital gains rate of 15% - the same rate paid by any similarly situated investor who buys a capital asset, manages the business, and sells it at a profit. Under the House bill, 75% of carried interest would be taxed as ordinary income beginning in 2013, at the top rate of 39.6% that will go into effect next January 1. The remaining 25% of carried interest would be taxed as capital gains. During the transition period until 2013, 50% of carried interest would be taxed as ordinary income and 50% as capital gains.

The Joint Committee on Taxation estimates the House bill would raise almost $18 billion over 10 years, assuming that firms continue similar levels of operations in the United States. The Senate version of the bill would tax 65% of carried interest beginning in January, 2013 as ordinary income, with the remainder taxed as capital gains, for a revenue gain of approximately $14 billion.

The taxation of carried interest is so complex that most Americans outside the legal and accounting professions do not understand it. These rules, adopted by the Department of Labor in the mid-1970s to let pension funds invest in capital ventures, have been in place for more than three decades.

Carried interest on real estate, private equity or venture capital investments is treated as a capital gain because it represents the profit earned from a capital asset whose acquisition and sale involves some risk. It is not guaranteed income. Investors in the stock market could see their assets skyrocket - or disappear - just like partners in private equity funds or real estate ventures.

Capital gains have generally been taxed at lower rates than earned income to encourage investment, and because investors supply the financial capital essential for investments that spur innovation, improve productivity, and expand capacity.

Some politicians say that carried interest bears greater resemblance to wage and salary income than to capital gains, so should be taxed at ordinary rates. But they miss the point: preferential capital gains treatment is afforded to owners to encourage investment.

General partners establish their ownership interest in these investment partnerships by contributing some capital, along with a significant amount of time, energy and expertise. Managing partners generally contribute personally between 1% and 4% of a partnership’s investment in a struggling business to be turned around, or in a start-up venture in a new technology. If the investment is unsuccessful, they receive no carried interest and lose their investment.

Raising taxes on hedge funds and private equity partnerships has a nice populist ring. But proposals to tax carried interest and the enterprise value of certain types of partnerships inconsistently target one sector of the economy. It makes no sense to tax the enterprise value of investment partnerships differently from partnerships that own auto dealerships, ice cream shops or family farms.

Partnerships often encourage innovation because they enable those with capital and management experience to team with entrepreneurs, supporting small businesses that create many of America’s jobs. Raising taxes would curtail entrepreneurs’ ability to plan for the long term.

With capital mobile in a global economy, it is especially important to ensure that America’s environment is hospitable to investment, so that economic activity is generated here rather than in London or Shanghai. Inconsistent taxation might make Congress feel fiscally responsible, but it would harm one of America’s most competitive sectors and slow the emerging recovery.

This piece originally appeared in RealClearMarkets

This piece originally appeared in RealClearMarkets