On the eve of the Super Bowl, President Obama re-ignited a long simmering debate by pointing to the tax treatment of income of hedge fund and private equity managers and others private investment managers under provisions known as "carried interests." The President suggested that as part of an effort to replace the rapidly approaching sequester spending cuts with a package of spending cuts and tax increases (loophole closings). The President specifically mentioned carried interest income as a prime example of a "loophole" that he believed should be closed in the interest of reducing the budget deficit/putting off the sequester now scheduled to take effect on March 1st.

Carried Interest

The debate about carried interest has been ongoing since at least the middle of the George W. Bush administration. As is the case with many hotly debated topics, even the description of the terms can be controversial. Carried interest refers to the practice of many hedge fund, private equity and other investment fund managers of taking their income as a percentage of the gains of the funds they manage rather than as management fees or  salary. Currently, that income is  treated as a capital gain rather than as ordinary  income. Effectively this means that carried interest income is taxed at 20 percent rather than 39.6 percent in 2013 (previously 15 percent and 35 percent). The proposals would treat carried interest income as ordinary income.  According to estimates from the Joint Committee on Taxation, that  change would generate $16.8 billion in additional revenue over the next ten years.

Legislation has been repeatedly introduced in Congress since 1987 to treat carried interest income as ordinary income. The Obama Administration and Democrats in Congress have repeatedly taken this position in various budget and tax proposals. But this move has been vigorously resisted by Republicans in Congress and, not surprisingly, the effected industries. To date, this resistance has blocked action to change the tax treatment of carried interest.

There are complex tax issues raised by carried interest. Fund managers and their advocates point out that all of the gains from their funds are generally treated as capital gains to their investors based on the sales of appreciated assets. Critics respond that though the gains of investors whot invest money in the funds are legitimately capital gains, the shares claimed by the fund managers are really comparable to fees paid to financial planners, lawyers, accountants and other similar professionals for services rendered rather than a return on investments of those managers. This issue is further complicated by the business structure of some private equity groups and real estate partnerships whose gains are returns on sales of businesses or other assets and whose owners include the managers.  Having to make distinctions between the portions of gain that are ordinary fee income and  investment gains from such sales would be extraordinarily difficult.

Political Landscape

2013 began with a political showdown between the Republican controlled House and President Obama on taxes and spending. That crisis was temporarily resolved with the main outcomes that the top individual tax rate was raised to 39.6 percent and the sequester across the board spending cuts (excluding some entitlements) of $1.2 trillion were put off until March 1st. Unfortunately, the rest of the year now appears to be a series of potential showdowns on the sequester, the Continuing Resolution (which funds government operations), and the extension of the debt limit (the government's ability to borrow). The debt limit would have likely come to a head in February, but now has been extended until sometime this summer. Each of those events could force a divisive debate on the fiscal policy of the country – cutting spending, entitlement cuts, and new tax revenues

Republicans have been vocal in demanding cuts in federal spending and have recently suggested that they might be willing to simply accept the harsh across-the-board cuts included in the sequester. Republicans have further argued that reform of entitlement programs, like Medicare, must be part of the discussion and that they are unwilling to agree to any additional tax increases.

Though the 2013 federal deficit is likely to be the lowest in five years thanks to tax increases, earlier spending cuts, and improving economy, President Obama and congressional Democrats seem to agree on the goal of reducing the federal deficit. However, they have continued to argue that this must be achieved through a combination of spending cuts and tax increases. For example they have discussed replacing the $1.2 trillion in sequester cuts with roughly $600 billion in spending cuts and $600 billion in new taxes. Democrats also have been less than enthusiastic about including cuts in entitlement programs in this discussion.

Political Outlook

This is the political context in which the carried interest issue will be debated in 2013. Clearly, it may be the tax increase that President Obama is most comfortable in advocating. Since most of its benefits flow to high income individuals it is also painted as a progressive measure. During the Presidential campaign it became clear that Mitt Romney – the Republican candidate and founder of the prominent private equity firm Bain Capital – had saved millions of dollars in taxes due to the treatment of carried interest income as capital gains. This makes Mr. Romney a face for advocates of changing the tax treatment of carried interest.

In truth though the $16.8 billion that treating carried interest as ordinary income would raise is a small fraction of the $600 billion in new tax revenue that is envisioned to replace the sequester cuts. Thus, we expect the debate will inevitably stretch beyond carried interest. Still, it is an attractive political talking point that President Obama and his allies are certain to continue to focus upon.

Republicans have successfully resisted changing the carried interest throughout the Obama administration and seem willing to continue the fight arguing that the increase in the individual rate to 39.6 percent is all that they are willing to agree to. But in the current fiscal context this position may be harder to sustain. The tax writing Committees in both Houses of Congress have looked at some of the technical issues involved in defining a carried interest provision and they concede that some issues deserve further attention, These details may prove critical if a major deal to reduce the deficit with spending cuts and new tax revenue does actually emerge in the course of the year.

When actual provisions are adopted, many fund managers who depend on favorable carried interest taxation may consider other structures and approaches to both existing and future transactions.  Furthermore, with Dodd-Frank limitations affecting investment participation by many financial institutions, changes in structures will have to address future investment opportunities.  Those, too, could affect the approaches to carried interest.