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Private Equity Tax Could Remedy AMT Pain

Nat Worden

Nearly everyone agrees that Congress needs to quickly pass legislation to stop an unintended quirk in an old law from raising middle-class tax bills -- especially now that American households are struggling to contend with a slowing economy and a nasty downturn in the housing market.

One might also assume that as the public gets increasingly disgusted by the runaway spending bills and debt accumulated by Congress, lawmakers would feel obligated to abide by their recent pledge to offset any further spending increases or tax cuts with matching tax increases or spending cuts.

The way things are shaping up now on Capitol Hill, lawmakers who want to achieve both will have to vote for a measure that requires investment partnerships -- such as private-equity firms and hedge funds -- to pay the same tax rates on management fees collected from their clients that everyone else pays on their ordinary income.

Currently, these elite investment managers pay the lower capital gains tax rate on so-called carried interest income. These earnings, which can represent a large chunk of profits, typically come from firms pocketing a fifth of the returns they generate with their clients' capital.

Last week, the House of Representatives passed a $76 billion bill that includes a one-year fix to prevent the alternative minimum tax from hitting an estimated 23 million households with incomes as low as $50,000. The AMT was originally created to make sure millionaires paid income taxes, but its levels haven't been adjusted for inflation.

The House bill, passed by the Democratic majority in a vote down party lines, would also double the tax on carried interest income for investment firms from the capital gains rate of 15% to the ordinary income rate of 30%.

That would raise an estimated $25 billion over 10 years and pay for roughly half the gap created by the AMT fix, which would cost the Treasury an estimated $50 billion over 10 years. The rest of the gap would be covered by a variety of other, less contentious measures in the bill.

Covering the gap is critical because the new Democratic majority reinstated "pay as you go" rules for Congress. These rules were abandoned by the Republican-controlled Congress in the early years of the Bush adminstration, heralding a surge in deficit spending by the U.S. government that has left the Treasury awash in red ink.

"Coming up with an offset for the AMT is really important, and [taxing carried interest income as ordinary income as opposed to capital gains] is one of the easiest conceptual things that's available now to Congress," says Joseph Bankman, a tax law professor with Stanford University. "Congress never likes increasing anybody's tax bill, but if you have to do it for some people, this is about as clear-cut a case as you're ever going to find."

Hedge funds and private equity firms are largely unregulated investment vehicles that are exclusive to the most well-heeled clientele in the world. As a group, they raked in staggering profits during the recent era of easy credit on Wall Street that has left the U.S. housing market reeling from an outbreak of foreclosures in low-income markets while the broader economy flirts with recession.

That said, the proposed legislation hardly singles out these firms. It merely closes a loophole by requiring them to pay the same income tax rates as their mutual fund counterparts, as well as doctors and lawyers and every other professional in the country.

"I do not criticize these [hedge funds and private equity firms]," said Rep. Barney Frank (D-Mass.) on the House floor last week. "I think they perform a useful economic function, but they are the wealthiest people in the country and in the history of the world on the whole. The notion that if they have to pay somewhat more tax up to the level that most of us pay on income, they will somehow go on an economic strike and stop doing these things is badly flawed."

Meanwhile, the third quarter is expected to show the first year-over-year decline in corporate profits for the S&P 500 since 2000, signaling that tax revenues for the federal government, which skyrocketed in recent years without coming close to erasing budget deficits, may be at a peak.

Some critics have objected to the measure on grounds that it would raise taxes on smaller business partnerships that hardly fit the profile of elite private equity firms, like Blackstone Group (BX Quote - Cramer on BX - Stock Picks) and Fortress Investment Group (FIG Quote - Cramer on FIG - Stock Picks). But Bankman has drafted language that could limit the legislation to larger firms.

"I'm positive that before anything is signed into law, an easy cure for small partnerships would be added to the bill," says Bankman.

Despite the compelling case that has been made for the measure in editorial pages across the country and by countless Wall Street luminaries, from Berkshire Hathaway's (BRK-A Quote - Cramer on BRK-A - Stock Picks) Warren Buffett to Vanguard founder John Bogle, the House bill has no counterpart in the Senate. Beyond that, it faces a veto threat from President Bush.

The major reason for the bill's cool reception in Washington, D.C. is the influence of the private-equity industry on K Street. Democrats from states that host a thriving population of investment firms -- like Connecticut Sen. Chris Dodd, New York Sen. Chuck Schumer and Massachusetts Sen. John Kerry -- have quietly signaled opposition to the bill.

The Center For Responsive Politics, a nonpartisan organization that tracks money and influence in U.S. politics, recently reported that investment funds were "ramping up their lobbying" as the debate over carried interest taxation began. Blackstone signed the largest single contract for lobbying services in the first half of 2007 -- a $3.7 million agreement with Ogilvy Government Relations.

Also, hedge funds have become a cash cow for Democrats. The industry reportedly contributed $4.4 million to House and Senate campaigns in 2006, and 77% of that went to Democrats.

For his part, President Bush and his Republican allies in the congressional minority are more than happy to watch Democrats come up empty-handed on the AMT fix or break their promise on pay-go.

"We are very focused on this and we're in touch with people on all sides [of the debate]," said Hamilton James, Blackstone's president and chief operating officer, on a conference call with analysts on Monday. "There is no consensus on either side. Even within the parties, they can't agree. There was not enough consensus, when this emerged in May, to even have a bill proposal yet from the Senate Finance Committee.

"One thing is for sure," added James. "They need tax revenues down there and they're going to get it from somewhere."