NEW YORK (CNNMoney.com) -- When you earn a lot of your living by investing others' money - is your take investment income or a regular paycheck?
The question was front-and-center Wednesday, when the Senate Finance Committee began a hearing about whether to raise taxes on a substantial portion of compensation for managers of private equity, venture capital and hedge funds.
Senator Charles Grassley (R-Iowa) said Wednesday that lawmakers' interest is not an attack on the investor class, it's not about raising revenue and it's not about raising the tax on capital gains, as some critics have charged.
"Keeping taxes low in investment returns is, I believe, very sound tax policy. But we need to preserve the integrity of that policy to maintain that policy," Grassley said.
The portion of compensation at issue is the manager's "carried interest," which is his share of the fund's profits. Typically, his share is 20 percent and the investors in the fund take 80 percent.
The manager, who makes all the decisions about the fund's investments, is not required to invest any of his own money. Indeed, less than 5 percent of assets managed by private equity and hedge funds is estimated to have come from managers.
But his share of the profits, like those of the investors who do put down cash, are treated as capital gains and taxed at 15 percent. Investment income is taxed more lightly than ordinary income to provide incentive to invest capital.
Key Democratic lawmakers in the House have introduced legislation that could double the tax on the manager's carried interest by treating it as ordinary income, thereby subjecting it to rates as high as 35 percent.
Their reasoning: it's really a fee for service.
That position has garnered public support from some in the investment world, most notably Robert Rubin, executive committee chairman of Citigroup and former Treasury Secretary under President Clinton. Speaking at a conference in June, he said, "I think what they're doing is getting paid a fee for running other people's money ... there is a very good argument for treating this as ordinary income."
Current law allows for a different interpretation, however, given how it defines and taxes partnerships - a common structure for alternative-investment funds.
The bottom line from the law books is this: Even if you don't put down money, you can be a legitimate partner in a fund - and be a co-owner of the assets.
"That's a pretty historic business structure. Money down is not necessarily a requirement of ownership," said federal tax analyst Mark Luscomb of CCH, Inc.
Fund managers also take a management fee of 1 percent to 2 percent, which is taxed as ordinary income. And when managers put in their own money, profits from that investment are treated as capital gains.
The Private Equity Council, a recently formed industry lobbying group, opposes any change to the taxation of carried interest. General partners not only contribute time and energy to managing a fund's assets but are required to mitigate losses so that investors get back the capital they put in, according to Council spokesman Robert Stewart. "They take entrepreneurial risk. (Carried interest) is not akin to getting a fee for service." He calls it a profit share.
Current Treasury Secretary Henry Paulson isn't backing a change, either. He told Reuters last week, "I do think we need to... step back and be careful here, thinking through unintended consequences."
One potential consequence of raising the tax on carried interest is the risk of lower returns, Stewart said, noting that managers might be less willing to take risks with investments if they know their tax bill will be higher. That, in theory, could hurt the pension plans, university endowments and foundations that have moved into alternative investments in search of higher returns.
Another consequence is that partnerships may find ways around any new regulations. "There are a lot of tax experts that can structure around any penalty," said Kurt Schacht, managing director of the CFA Center for Financial Market Integrity, a nonprofit research organization in Charlottesville, Va.
The proposal put forth by House lawmakers would essentially redefine what partnerships are, and some say that's too blunt a move to change the taxation rules on one group of partnerships.
More moderate proposals might, for instance, preserve the notion of "service" partner but define what constitutes reasonable compensation for service. Or it may allow managers to characterize carried interest as capital gains under certain conditions, much the way gains on stock options can be treated as capital gains if you pay for the shares at the strike price when you exercise them, Luscomb said.
The debate is being conducted as lawmakers seek to raise revenue to shore up various projected shortfalls due to entitlement obligations, alternative minimum tax reform and the cost of the war in Iraq among other things. There are no firm estimates yet on how many managers would be affected if carried interest is taxed as ordinary income or how much tax revenue would be gained - or lost - as a result. 
