The House passed today a provision which would impose ordinary income tax rates and self-employment taxes on 75% of the carried interest earned by investment fund managers, including principals of venture capital funds. The tax increase was included in a bill extending unemployment benefits. The tax hike on the "carried interest," if approved by the Senate, will not become effective until the start of tax year 2011 (although only 50% of the carry would be taxable as ordinary income for taxable years beginning before January 1, 2013). The Senate is set to consider the bill next week.
The tax increase is a dramatic increase over the current 15% capital gains tax rate. In addition to subjecting 75% of what would otherwise be taxable at 15% rates to ordinary income tax treatment, the bill would would also require recipients to pay self-employment taxes on the income.
It is unclear yet what impact this bill will have on the venture capital industry, or investments in early stage companies. It would appear that at the very least there may be changes in how some investments in early stage companies are structured. Despite the bill, there may still be opportunities for principals in investment funds to garner capital gains treatments with respect to certain components of their investments if structured properly. Regardless, it seems safe to say that this tax bill is going to shake up the industry.
From the summary of the current version of the bill:
"Taxation of carried interest. The bill would prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as carried interest in an investment fund. To the extent that carried interest reflects a return on invested capital, the bill would continue to tax carried interest at capital gain tax rates. However, to the extent that carried interest does not reflect a return on invested capital, the bill would require investment fund managers to treat seventy-five percent (75%) of the remaining carried interest as ordinary income (50% for taxable years beginning before January 1, 2013). The provision will be effective for taxable years ending on or after January 1, 2011. This proposal is estimated to raise $17.697 billion over 10 years."
For more information, see the press release page for the House Committee on Ways and Means.