Question: Carried Interest Taxation Introduction Congress threatened to increase from 15 percent to 35 percent the tax rate on the income of partners in private equity firms, venture capital firms, and some real estate and oil and gas partnerships. Partners in these firms received a share, typically 20 percent but as high as 30 or 40 percent for some elite firms, of the gain on investments above a predetermined high water mark, with the remainder going to the limited partners and outside investors. The 20 percent economic interest in the venture typically was greater than the partners' investment of their own capital, so the economic interest did not represent a return on capital. Their economic interest was preferred to as carried interest or "sweat equity" as some in the industry referred to it. Carried interest was currently treated as a long-term gain and taxed at the long-term capital gains rate of 15 percent. Legislation passed by the House of Representatives would treat carried interest as ordinary income, which was taxed at a 35 percent rate. Victor Fleischer, a law professor at the University of Illinois-Chicago, testified in a congressional hearing, "This quirk in the tax law is what allows some of the richest workers in the country to pay tax on their labor at a low rate."39 On his blog Harvard University economics professor Greg Mankiw quoted economist and columnist Paul Krugman, who had asked, "why does Henry Kravis pay a lower rate on his management fees than I pay on my book royalties?" Mankiw answered, "In both cases, a person (investment manager, author) is putting in effort today for a risky return at some point in the future. The tax treatment should be the same in the two cases."40
Douglas Lowenstein, president of the Private Equity Council, argued, "The proposal would undo decades of established partnership tax law and create a new standard that reserves capital gains rates only for those with the wherewithal to invest equity into an enterprise. Congress should not raise private equity taxes by 130 percent and create the risk that some of the benefits of this economic activity could be discouraged. Partners ‘who invest their time and effort to add value to an asset they own' are rightfully paying the lower capital gains rate on the resulting investment profits."41 Background Some critics of the current tax treatment, including unions, were opposed to private equity firms because jobs were frequently eliminated when acquired firms were restructured. Other critics cited the extremely high incomes of private equity firm partners. Stephen A. Schwarzman, a co-founder of the Blackstone Group, earned $684 million in 2006 and held a $3 million birthday party that included entertainment by Martin Short and Patti LaBelle. Blackstone went public in June 2007 with a market capitalization of $33 billion, and Schwarzman's share was valued at $7.5 billion. The bill to increase the tax on carried interest was introduced in the House the day after Blackstone went public. Senator Gordon Smith (R-OR) chided his colleagues, "It seems to me we were brought to this hearing because of the extravagant lifestyle of one person."42 The legislative threat, however, was not due to extravagance but to a flaw in the personal income tax law and a "pay as you go" pledge by congressional Democrats. The flaw was the adjusted minimum tax (AMT) which threatened an additional tax burden on 23 million taxpayers. In 1968 the AMT had been enacted to make certain that wealthy individuals could not avoid personal income taxes.
The flaw was that the income at which the AMT took effect was not adjusted for inflation. If Congress did not act, the AMT exemption income would fall from $62,550 in 2006 to $45,000 in 2007 for taxpayers filing joint returns with the average increase in taxes estimated at $2,000 per taxpayer. Most members of Congress viewed the AMT as unneeded and a political hazard and wanted it eliminated. In 1990 Congress adopted a "pay as you go" rule in a bipartisan effort to reduce the budget deficit. Congress began to waive the rule in the late 1990s, and in 2002 the Republicancontrolled Congress allowed the provision to expire.43 When the Democrats won majorities in both chambers in 2006, they resurrected the "pay as you go" provision to demonstrate their fiscal responsibility in light of what they claimed was uncontrolled spending by the Republican Congress.44 The rule required that any tax revenue lost from the reduction or elimination of the AMT be made up by increases in revenue from other taxes. Legislation Charles Rangel (D-NY), the new chairman of the House Ways and Means Committee, introduced major tax reform legislation in the form of the Tax Reduction and Reform Act of 2007. The $796 billion (over 10 years) bill provided for the permanent repeal of the AMT and a reduction in the corporate profits tax rate from 35 percent to 30.5 percent.45 To make up the lost revenue, the bill would tax carried interest at 35 percent and impose a 4 percent surtax on individual incomes above $150,000 and $200,000 for couples filing a joint return.46 The bill would also eliminate a special tax rate for manufacturers, disallow for tax purposes the use of the LIFO accounting method for inventories, and disallow certain deductions associated with untaxed foreign profits.
Inter Media Partners LP, a private equity firm, stated in testimony before the House Ways and Means Committee, "A tax loophole the size of a Mack truck is right now generating unwarranted and unfair windfalls to a privileged group of money managers, and, to no one's surprise, these individuals are driving right through this $12 billion-a-year hole. Congress, starting with this committee, needs to tax money management income-what we call carried interest-as what it is, which is plain old ordinary income."59 William D. Stanhill, founding partner of Trailhead Investors in Denver, stated in testimony, "I don't think it's fair for ... teachers and firefighters to subsidize special tax breaks for me and other venture capitalists. Or for private equity and hedge fund managers."60 He also stated that a higher tax rate would not affect venture capital, "We get ample compensation, financial and psychic, for the work we do and the risks we take."61 Warren Buffett supported a tax increase. Referring to when he ran an investment partnership, he said, "I was managing money for other people ... believe me, it's an occupation. I believe you should tax people on carried interest."62 Earlier in June he had told a gathering of 400 venture capitalists and money managers gathered to raise funds for Senator Hillary Clinton (D-NY), "The 400 of us [here] pay a lower part of our income in taxes than our receptionists do-or do our cleaning ladies, for that matter. If you're the luckiest 1 percent of humanity, you owe it to the rest of humanity to think about the other 99 percent."63 In October the Service Employees International Union staged a protest against the Carlyle Group with a street theater depicting executives such as David Rubenstein as "Fat Cat Tycoons."
For Halloween the union repeated the performance, including a protester dressed as "Sugar Daddy David Rubinstein" who handed out candy to mock lobbyists.64 Professor Fleischer commented, "The Private Equity Council has done a great job using sound bites to shape the debate. It started out as a debate about the tax rates that wealthy fund managers pay. Now it's about whether tax reform would hurt pensioners, minorities, and destroy capitalism as we know it."65 In September venture capitalists gathered for lunch in Palo Alto, California, and Mark Heesen of the National Venture Capital Association (NVCA) warned the group that "We are in a true battle." The NVCA sought to distance itself from the money management firms. Emily Mendell of the NVCA stated, "We are making distinctions between the long-term nature of venture capital investment versus the shorter-term economics that the other funds employ. We have a unique argument-we don't do arbitrage, we don't do financial engineering, we make assets from nothing. We build companies." Ted Schlein, a partner at Kleiner Perkins Caufield & Byers and chairman of NVCA, said, "If Congress is serious about promoting a competitiveness and innovation agenda and supporting new energy technologies, then it should be extremely thoughtful before it passes legislation which will discourage investments in the startups and small businesses that are key players in these arenas." Jonathan Silver, a venture capitalist with Core Financial Partners, stated in testimony before the House Ways and Means Committee, "Early-stage companies would be harder to form and fund, reducing the overall number of venture-backed companies and hurting the lifeblood of our entrepreneurial ecosystem."66
Legislative Developments The Senate was considering a bill to increase the tax on carried interest only for private equity firms that went public. Blackstone wrote to Senator John Kerry (D-MA) that the bill under consideration by the Senate Finance Committee would increase the Group's taxes by $525 million a year and partners' taxes by $175 million and would reduce its market capitalization by $10.5 billion. Senator Kerry had compared "private equity executives with other entrepreneurs who risk their own capital and therefore merit special tax treatment."67 Senator Charles Schumer (D-NY) planned to introduce a bill that would increase taxes on all partnerships in addition to those generating carried interest. On an 88-5 vote the Senate passed its own tax bill, which eliminated the ATM for 19 million taxpayers, reducing their taxes by $51 billion. The Senate, however, opposed any tax increase and waived the "pay as you go" rule. Senate Majority Leader Harry Reid (D-NV) had decided not to push the tax on carried interest because Republicans had threatened a filibuster and Democrats would be unable to invoke cloture and bring the bill to a vote. Senator Barack Obama (D-IL) issued a statement in response: "If there ever was a doubt that Washington lobbyists don't actually represent real Americans, it's the fact that they stopped leaders of both parties from requiring elite investment firms to pay their fair share of taxes, even as middle-class families struggle to pay theirs."68
Rangel's tax reform bill was bogged down because of its complexity, and needing to deal with the AMT issue so that the Internal Revenue Service could prepare the 2007 tax forms and tax refunds would not be delayed, Rangel introduced a bill to provide a 1-year fix. The $76 billion bill would freeze the AMT for 1 year, extend some popular tax credits for families, and increase the tax on carried interest.69 On November 1 on a 22-13 vote the Ways and Means Committee passed the bill, and the full House approved it within a week on a 216-193 vote. After the committee vote, Lowenstein of the Private Equity Council said, "We are disappointed with the committee's actions today, and we will continue to oppose legislation to change the tax treatment of carried interest. We remain hopeful that in the end this legislation will not be enacted into law."70 With time fleeting, the House and Senate conferred and agreed to the House freeze on the AMT but dropped the tax increase on carried interest, sending the bill to President Bush for his signature. Lisa McGreevy of the Managed Funds Association commented, "This issue is definitely still on the table and will stay there until major tax reform is passed."
1. Evaluate the strategy used by the private equity industry to deal with the threatened increase in taxes on carried interest.
2. Should the venture capital industry join with the private equity industry, or should it separate from the private equity industry? That is, is it better for the venture capital industry to join with the private equity industry in a broad coalition to defeat higher taxes on carried interest, or should the venture capital industry pursue, either as a primary or a contingent objective, an objective such as taxing as ordinary income carried interest associated with money management and private equity but not taxing carried interest on venture capital investments associated with creating jobs?
3. Now that Rangel's legislative effort failed, will the carried interest issue go away?
4. If the tax on carried interest were increased, what would be the effect on the private equity and venture capital markets? How should firms in those industries adjust their market strategies?
5. Formulate a strategy for the venture capital industry to deal with the carried interest taxation issue.