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The Tax Man Cometh, Perhaps, for Private Equity

Fueled by budget pressures and a desire to ensure fairness in the tax code, Congress is weighing two controversial proposals that would raise taxes on private equity firms.

One measure applies only to publicly traded partnerships, such as The Blackstone Group, while the other goes further by raising taxes on “carried interest,” which comprises the bulk of profits for most private-equity fund managers.

Rep. Sander Levin (D-Mich.), a senior member of the Ways and Means Committee, is leading the charge on legislation that would increase taxes on investment fund managers.

Specifically, his bill (H.R. 2834) would require private equity and hedge fund managers who take a share of a fund’s profits as compensation — an amount known as carried interest — to pay income tax rates on that compensation, rather than capital gains taxes. Currently, capital gains rates are 15 percent, but the ordinary income tax rate for someone in the top tax bracket is 35 percent.

Opponents of the legislation argue that carried interest differs from compensation in other fields — and should continue to be taxed as capital gains — because of the financial risk involved in venture capitalism. The bill also could harm small businesses and pension funds, some argue.

Supporters maintain that the issue is about whether the lower capital gains tax rate is being inappropriately substituted for the tax rate on wages and earnings.

Ways and Means Chairman Charlie Rangel (D-N.Y.) has offered support for Levin’s bill, which he has said addresses “a basic issue of tax fairness.”

Rangel plans to unveil his own comprehensive tax reform legislation that is expected to link a carried interest tax hike, among other changes in the tax code, to a repeal of the unpopular alternative minimum tax.

Lawmakers are awaiting the official Joint Taxation Committee score on Levin’s legislation. A recent academic study estimated that Levin’s proposal could net an extra $2 billion to $3 billion per year, at most, if the structure of private equity funds does not change.

Senate Finance Chairman Max Baucus (D-Mont.) has not stated his position on carried interest taxation, though he is expected to hold more hearings on the issue in the coming weeks.

Neither Baucus nor Rangel have commented on a broader proposal being drafted by Sen. Charles Schumer (D-N.Y.) that would raise taxes on carried interest across all industries. Other entities that offer carried interest include real estate, oil and gas ventures, and even shopping centers. Schumer has yet to unveil his legislation.

Private equity firms are lobbying hard against the proposed tax hike: The Center for Responsive Politics, a nonprofit research group that tracks money in politics, this month reported that Blackstone signed the largest lobbying contract for the first half of 2007 — $3.7 million with Ogilvy Government Relations.

At a recent Ways and Means hearing on carried interest, however, many private equity sector representatives “broke ranks” with those who argue that a tax hike will hurt the economy, according to a House Democratic aide.

“The public face” of the private equity sector says that a carried interest tax increase will lead to a drop in investments, the aide said. But in private, many recognize that the current tax rate of 15 percent is “a tax break,” and one that may not be justified.

With many lawmakers still seeking a grasp on the implications of a carried interest tax change, it remains unclear whether there is enough support in Congress to pass the measure.

“I seriously doubt this proposal will become law during the 110th Congress,” Ways and Means ranking member Jim McCrery (R-La.) said during a recent hearing.

Additionally, the House and Senate do not appear to be working closely on the issue.

A House source close to negotiations on the matter summed up the state of affairs between the two chambers: “Right now, we are moving in our direction, they can move in theirs.”

Meanwhile, Baucus and Finance ranking member Chuck Grassley (R-Iowa) have filed legislation that would affect the private equity sector in a more limited manner: It would tax publicly traded partnerships as corporations.

Their bill (S. 1624) would impose corporate rates as high as 35 percent, rather than the current 15 percent capital gains tax rate, on private equity firms that choose to go public.

While the measure would have the effect of deterring businesses from structuring themselves as publicly traded partnerships, its primary target is two current investment firms: The Blackstone Group and Fortress Investment Group.

Grassley has said he agrees with those who say corporate taxes are too high, but he said that is a different debate.

“I’m not going to stand by and watch a significant part of our economy escape the corporate tax system while still accessing corporate markets,” he said during a July hearing.

Grassley has speculated that a private equity tax change will be attached to AMT reform since it is expensive and Members need to look for ways to offset the tax relief. Baucus has yet to discuss a possible link.

Rangel has said he plans to include the partnership tax change in his tax package but has not offered any details.

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