The U.S. Senate could start voting on tax reform legislation as soon as later this week and included in the package of measures is a provision targeting a subset of hedge funds, a category of investor that Trump has insisted were "getting away with murder."
At issue in the battle over taxes is the way carried interest - the profits received by many hedge funds, private equity managers, and venture capitalists - is treated as capital gains with a top basic rate of 23.8% as opposed to the top ordinary income rate of 39.6%. A move to treat carried interest as ordinary income could significantly increase the amount of taxes fund managers pay.
A measure included in both House and Senate legislation leaves the tax break in place but puts restrictions on a small category of the investment sector. Specifically, the proposal would limit the carried-interest tax break by increasing the length of time assets would need to be held to qualify for the break, from one year to three years.
The goal of the change is to keep in place the treatment for firms that create jobs, but hike taxes on those that don't. The idea is that it is easier to argue that private equity firms, real estate companies and venture capitalists for the most part create jobs while hedge fund managers do not and therefore the first category investments should be protected from any tax change while the second sector, hedge funds, should not.
If an agreement is reached Tuesday, the Senate could start voting on tax reform legislation on Wednesday and Thursday, and lawmakers n the chamber could conceivably approve the bill before the end of the week.
All this is good news for top buyout shop managers like billionaire private equity mogul and Blackstone Group co-founder Stephen Schwarzman, who was chairman of President Trump's strategic and policy forum until it was disbanded in August.
Mark Proctor, a partner at Vinson & Elkins LLP in New York, said if approved the measure will generally not have an impact on taxation of private equity fund managers, real estate firms or venture capitalists because the investment strategies employed by these individuals tend to hold assets for more than three years. Private equity firms typically have funds that hold portfolio companies for up to seven years before a business is sold or taken public.
Under current law, the lower long-term capital gains rate kicks in once an investor holds an asset for more than a year. Proctor noted that some hedge fund strategies, such as high-frequency-trading, hold their investments for less time. As a result, incentive fees paid to managers who employ these strategies currently don't qualify for the lower capital gains treatment and they won't be impacted by the change. However, he added that managers who pursue longer-term "buy and hold" strategies, including activist hedge fund operators, would more likely be impacted.
Kai Haakon Liekefett, head of the shareholder activism response team at Vinson & Elkins, agrees that such a tax change if implemented would hurt activists. "Activist hedge funds by nature need to be able to retain the ability to cut and run if need be," Liekefett said. "If they have to hold for three-plus years to avoid a tax penalty that would create a serious problem for a lot of hedge funds whose strategies are often based on shorter holding periods."
But overall, new taxes on some hedge funds won't bring in nearly as much revenue to the U.S. government as initially anticipated. The Treasury Department estimated in 2016 that $19 billion would be raised over ten years from treating carried interest as ordinary income, up from about $18 billion over ten years as estimated in the government's 2015 budget.
However, the proposed change in tax law wouldn't lead to a dramatic increase in revenue raised from carried interest because it would only impose the tougher tax treatment on a small subset of all the types of funds that currently benefit from the carried interest provision. University of San Diego Law Professor Victor Fleischer tweeted on Nov. 8 that the The Joint Committee on Taxation, which reviews tax policy, gauges that only $1.2 billion would be raised over ten years, roughly $120 million a year, from the carried interest amendment, calling it a bad joke and noting that taxing a couple fund managers, including Schwarzman, at 39.6% could bring in as much.
The tax treatment could also have a broader impact on activist hedge fund strategy. Proctor suggests that the tax treatment could create a bias to hold securities for longer periods of time. He added that some activist fund managers may become reticent about launching a campaign at a particular targeted business for fear that they would be punished with higher taxes if their position is liquidated in less than three years. "They'll be cautious and may choose not to launch a campaign if they see a situation where they might have to get out quickly,' Proctor said.
Another discouraging factor involves hedge fund holding periods. While most private equity funds lock up their investors' capital for up to 12 years, hedge funds, for the most part, offer their investors liquidity. Hedge fund investors in many situations can choose when to withdraw their capital - as a result, fund managers do not have as much control over how long they hold their investments.
"If a lot of a hedge fund's investors redeem their positions it creates a situation where the fund manager needs to liquidate its positions," Proctor said. "That may mean they would have to sell equity that they have held for less than three years."
During the 2016 election campaign candidate, a bipartisan consensus appeared to form among top candidates, Trump, Hillary Clinton and Bernie Sanders, that it was time to raise taxes on fund managers of all kinds. The prevalent idea around this was to treat carried interest as ordinary income. However, it is becoming increasingly clear that there never really was a consensus on the issue, with many suggesting that a Democratic administration would have sought to hike taxes on a much broader group of fund managers, including those managing private equity and real estate.
Proctor noted that Trump's background is in real estate and many of his advisers come from the private equity and real estate worlds, all of which likely informed his perspective on the issue.
"The President had to come up with a solution to make good on his promise but at the same time didn't want to hurt the economic interests of real estate investors and private equity investors," Proctor said.
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Editors' pick: Originally published Nov. 17.