As expected (by peHUB at least), President Obama’s proposed fiscal 2010 budget includes a provision to reclassify the tax treatment of carried interest, from capital gains to ordinary income. This would dramatically increase the taxes paid on profits by buyout firms, venture capital firms, hedge funds and any other investment partnership (real estate, timber, oil, etc.).
The basic math is that this change would raise a PE firm’s taxes on investment profit from 15% (current cap gains rate) to around 35% (ordinary income level for top brackets). That’s a big jump, although it’s worth noting that capital gains rates themselves are universally expected to rise to at least 20 percent.
As I’ve written ad nauseum, this is a change I support. Carried interest is, at its heart, a fee for services. A buyout pro or VC should not receive capital gains treatment on take-home generated by investing someone else’s money. The limited partner is the person or institution that took the capital risk, so it’s the one deserving of the capital gains rate (and would continue to receive it under Obama’s plan). If a buyout pro or VC contributed personal capital to their fund — which they normally do — then they’ll continue to pay the lower rate on those pro rata profits.
The relevant trade associations — NVCA and Private Equity Council — obviously disagree with my assessments, and certainly will lobby hard to get this proposal stripped from the final budget. Their basic argument will be that this proposal discourages investment, at the very time when America needs more of it. I can’t say that this won’t work — remember, similar proposals have fallen flat before, albeit with the aid of presidential veto threats — but can say that it’s a specious argument.
I’ve discussed carried interest taxes with more than 100 investment pros (not an exaggeration), and found exactly one who claims he would quit were this change enacted. The rest will bitch, moan and then keep doing their jobs. Maybe their attorneys will try to find a new loophole, but even that would likely apply to new funds rather than to existing ones. No firm with significant dry powder is going to just close up shop and hand back the money, because the taxes on potential profits are higher. Maybe they’ll try raising their management fees, but they won’t stop investing.
To quit would be neither in their nature, nor in their self-interest.
Update: Here is the Private Equity Council statement