Another Run at Taxing Carried Interest

By :: May 13th, 2010

TaxVox’s very first article—in October, 2007—was about congressional efforts to tax the compensation of hedge fund and private equity managers as ordinary income rather than capital gains. For three years now, the House has passed such a tax on this income, known as carried interest. And for three years the levy has died in the Senate.

Now it appears we are going to play out this little comedy once again. But I’m wondering if the outcome is going to be different this time. Why? Financial firms are, let us say, in somewhat bad odor these days. Their lobbyists are focused on watering down the massive financial reregulation bill working its way through Congress. And Senate Democrats, who have pledged to abide by so-called PAYGO budget rules, need money to offset the cost of extending dozens of expiring tax breaks

When it comes to tax cuts, the Senate’s idea of PAYGO has been “we go and your grandkids pay.” It is not likely to fund the $60 billion one-year cost of continuing to exempt 30 million middle-class households from the Alternative Minimum Tax. Nor will it offset the expense of liberalizing the estate tax (probably another $20 billion, depending on what Congress does), once that levy returns from its bizarre one-year hiatus in January. But, faced with a $1.3 trillion deficit, the Senate may pay to extend those expiring business tax breaks. And the Joint Committee on Taxation figures taxing carried interest as ordinary income will raise about $20 billion.       

There is one more reason why carried interest may take a hit this year. Given all the talk about a bank tax of some sort, financial firms may find themselves in the fiscal shark tank where it is every predator for himself. And somebody in the pool is going to get hit with a new tax. In that environment, the hedge funds may well be the chum. Office of Management and Budget Director Peter Orszag is among those who thinks so.

On the merits, this is an easy call. Carried interest is a hedge fund partner’s performance-based management fee cleverly disguised as a return on his invested capital. It is a triumph of form over substance, and it should be taxed as ordinary income. We’ll see if, after years of pretending otherwise, the Senate finally agrees.