Managers' taxes: Big concerns could table hike

NEW YORK (CNNMoney.com) -- The critics of legislation that would raise taxes on the income of private-equity and hedge-fund manager are coming out in full force, contending it would hurt returns and have negative effects on other kinds of limited partnerships. In addition, they say, not much tax revenue would be raised.

The prospect of hiking taxes on private-equity and hedge-fund managers will be the topic du jour at simultaneous hearings held by the House and Senate tax-writing committees on Thursday.

The Senate hearing - the third of its kind this year - will focus on how such a tax hike will affect pensions, which are major investors in private equity and hedge funds. The House hearing will focus on the fairness of such a tax increase.

Those who oppose increasing the tax on the so-called "carried interest" portion of fund managers' compensation contend, among other things, that it will stifle risk-taking or drive away the best managers altogether.

Carried interest is the managers' share of a fund's profits. Even though managers don't necessarily invest their own money in a fund, their carried interest is taxed as a capital gain at 15 percent instead of at ordinary income tax rates that can run as high as 35 percent. A House bill proposes it be treated as ordinary income because some lawmakers characterize the managers' work as a fee for service.

Critics also contend that such a hike would cause private equity funds to restructure in ways that avoid the tax hike, thereby limiting the amount of additional revenue lawmakers hope to raise to help pay for Alternative Minimum Tax (AMT) reform and other goals under Congress's pay-as-you-go mandate.

The Joint Committee on Taxation has yet to offer its official revenue estimate - which is what lawmakers must use in making their decisions. But one academic study by University of Pennsylvania Law Professor Michael S. Knoll concludes that at most the tax hike would net an extra $2 billion to $3 billion.

If the move causes private equity funds to change their structure, Knoll wrote, "[i]t is possible that there will be little or no net increase in tax collections ... ."

The bill's prospects for passage are also uncertain because of fears such a change could have far-reaching consequences for all other types of partnerships.

"Our view has been that the carried interest bill doesn't have good long-term prospects because it's too far-reaching and can be construed as being applied to all partnerships. It's vulnerable to the law of unintended consequences," said Anne Mathias, director of research for the Stanford Washington Research Group.

Indeed, "the whole partnership community is upset that the deals they've been structuring for years could be caught up in this," said Mark Luscombe, federal tax analyst at CCH, Inc.

That doesn't mean, however, that it's dead in the water. Even if official estimates project that the bill would net $3 billion or less, Mathias said, lawmakers could very well include a number of sub-$5 billion revenue raisers in a bill that calls for popular measures such as AMT reform, estimated to cost $50 billion a year.

Luscombe agreed. "They're after any revenue raiser they can find regardless of how low."

But Mathias does think another bill tied to the taxation of private equity managers has a better chance of passing because it is narrower in scope. That bill, proposed by Senate Finance Committee Chairman Max Baucus (D-Mont.) and Ranking Member Charles Grassley (R-Iowa), would tax private equity partnerships that go public as corporations rather than partnerships.

It deals specifically with the taxation of partnerships that derive more than 90 percent of their income from passive income. The rule was intended for partnerships that invest in passively managed investments (such as stocks) and not actively managed assets such as companies that the partnership has bought and is running, Mathias said.

Right now, if a private equity partnership goes public - as Blackstone did earlier this summer - it would pay the 15 percent capital gains on that passive income. Under the bill, the partners would be subject to the corporate income tax, which can run as high as 35 percent.