Uncle Sam Eyes Bigger Piece of Funds' Treasure

The debate on private-equity's low carried interest tax rate is heating up.
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With U.S. consumers defaulting on their mortgage loans at record rates, their representatives in Washington, D.C., are struggling with their own borrowing binge -- the national debt.

Now both situations have the hedge funds and

private-equity firms that benefited most from the era of easy credit potentially paying a price.

When the mortgage meltdown created headlines, credit dried up in the world's financial markets, halting the parade of leveraged buyout deals and reducing Wall Street's private-equity boom to a whimper. In D.C., members of Congress are taking aim at the sweet tax status long enjoyed by investment firms in an effort to raise much-needed revenue for Uncle Sam.

On Thursday, both houses of Congress held hearings on taxation issues, with a focus on whether carried interest income for fund managers should be taxed at the regular income tax rate of 35% instead of the lower capital gains rate of 15%.

Typically, hedge funds and private-equity firms charge their clients an annual fee that amounts to roughly 1% or 2% of the funds under management. Additionally, the firms are often paid roughly 20% on the returns they generate when their investments are successful. It's that additional performance-based compensation for the fund manager, known as carried interest, that is classified as a capital gain and taxed at the lower rate.

The arrangement stems from partnership laws designed to encourage financiers to provide capital for entrepreneurs to start and grow a business. In a partnership, entrepreneurs can negotiate a stake in the business with investors so if the venture is successful and ultimately sold, their share of the returns will be taxed at the lower capital gains rate.

Fund managers compare themselves to the entrepreneur, since they use their investment expertise to grow their clients' money. Critics say the fund managers are providing a service to clients, just like a doctor or a lawyer, so all their compensation should be taxed like everyone else's -- at the 35% income rate.

In 2005, capital gains from partnerships and similar business structures amounted to 22% of total current-year long-term capital gains reported on individual income tax returns, according to Peter Orszag, director of the Congressional Budget Office. Meanwhile, 27% of the gains were recorded by the 1% of taxpayers with the highest income.

Those numbers reflect the recent success of elite fund managers, like

Blackstone's

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Steve Schwarzman, Kohlberg Kravis Roberts' Henry Kravitz and Cerberus Capital Management's Steve Feinberg. Their firms have little in common with a fledgling business. And while some managers invest their own capital in their funds, the vast majority of capital for these investments comes from their clients, leaving the managers with little to no personal risk.

As a result, billionaires like Warren Buffett are paying a lower tax rate than their receptionists, as the legendary investor recently pointed out in a letter to shareholders. At the same time, the U.S. is funding two expensive wars in the Middle East and spending massive amounts on social programs and homeland security. Also, the Baby Boomer generation is retiring, there is no sign of political will to rein in entitlement spending and the economy is at risk for a slowdown.

In this climate, Congressional leaders from both parties are considering ways to eliminate the alternative minimum tax, which is increasingly hitting the middle class, while not losing revenue. Doubling the tax on carried interest income for fund managers at investment partnerships would help make up for those lost funds.

In the House of Representatives, Michigan Democrat Sandy Levin wrote a bill with New York Democrat Charlie Rangel and Massachusetts Democrat Barney Frank that is being debated in the Ways and Means Committee.

In the Senate Finance Committee, Democratic chairman Max Baucus of Montana is holding hearings in cooperation with the ranking Republican, Chuck Grassley of Iowa.

Ideologues on both sides are heating up the debate by morphing it into an argument over the merits of the disparity between the income tax rate and the capital gains rate. The House legislation doesn't seek to raise the capital gains tax rate, since it is intended to spur innovation. It only defines carried interest compensation for investment fund managers as regular income.

"We justify the lower rate on capital gains as a remedy against the double taxation of investment income and the resulting benefits of economic growth," said Grassley at a hearing. "As a Republican who supports lower capital gains rates, I am concerned that to the extent we permit the dilution of the investment concept, we risk undermining the arguments we have made for the lower rates, and also making it more expensive to extend them."

The U.S. Chamber of Commerce, the nation's largest business lobbying group, argued against the legislation in a recent report, concluding that taxing carried interest at a higher rate would stifle economic growth by sending huge pools of investment capital abroad in search of more favorable tax rates.

A consortium of minority and women business leaders called the Access to Capital Coalition also came out opposed to the legislation, arguing that it would hurt investment funds that provide capital to minority entrepreneurs. The group is funded in part by the Private Equity Council, a lobbying group that serves private-equity giants. It also enlisted the support of basketball legend Earvin "Magic" Johnson, who runs an investment fund.

Private-equity firms have argued that raising their taxes would hurt pension funds and university endowments, which deploy a portion of their capital in private equity. But in a letter to the Senate Finance Committee this week, the president of the National Conference on Public Employee Retirement Systems said a majority of its members don't think the legislation would affect pension plans.

In the Senate hearing on Thursday, Foundation for Fiduciary Studies President Donald Trone estimated that the legislation could lower returns for pension funds by one basis point. Russell Read, CEO of the California Public Employees' Retirement System, said the legislation didn't pose a major concern for his fund.

Joseph Bankman, a law professor at Stanford University, says the legislation could be modified to exclude small business partnerships that could suffer from the changes.

"The recipients of profits in those partnerships tend to more closely resemble entrepreneurs than do fund managers of larger partnerships," says Bankman.

In arguing his own case in the Senate, Bruce Rosenblum of private-equity firm The Carlyle Group may have inadvertently provided fodder for proponents of the tax change.

"When you buy coffee in the morning at Dunkin' Donuts, see a movie produced by MGM Studios, or shop at Toys R Us,

J. Crew

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, Petco, or

Auto Zone

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, to name just a few, you are interacting with private-equity companies," said Rosenblum. "Private-equity companies also own some of the office buildings in which we work, supply parts and equipment for the cars we drive and the airplanes we fly, and even deliver the power that lights our homes in some parts of the country."

Is an industry of that size really deserving of a special tax break?