Congress eyes new tax on private equity

May 17, 2007, 6:06 PM UTC

Last week staffers on Congressional tax-writing committees held a closed-door meeting with various tax experts (lawyers and academics, primarily) to discuss changing the way private equity firms are taxed. To boil down a complicated topic, partners in private-equity firms – which include buyout funds and venture capital firms – typically pay ordinary income tax only on their management fees, usually 2% of assets under management. Their “carry,” or their share of any profits they generate for their investors, are taxed as long-term capital gains. (That’s a 35% tax rate for rich people earning ordinary income versus 15% for all long-term capital gains.)

It doesn’t make a hell of a lot of sense since the buyout and VC partners aren’t investing any money, just their time and effort — which is kind of what I invest when I go to work every day. (If they do invest actual money, that’s a different story, of course.) Henry Blodget has a good take on the topic in his blog, the Internet Outsider, and a New York Times editorial in April urged Congress to tackle this issue, arguing that capital gains receive “excessive” preference in the current tax code. I also have an article in the current issue of Fortune that discusses how VCs are trying to distance themselves from their buyout brethren, even though their partnerships are structured exactly the same way.

Anyway, at this closed-to-the-public meeting, the staffers (no lawmakers attended) took a mostly fact-finding approach, suggesting they haven’t decided what if any proposals they’ll put forward to change how firms are taxed. They also showed an interest in broader issues, like offshore tax shelters, a key device used by hedge funds. They heard from tax gurus including Jack Levin of Kirkland & Ellis, Dana Trier of Davis Polk, Victor Fleischer of the University of Colorado, Arturo Requenez of McDermott Will & Emery and Stuart Leblang of Akin Gump.

When I’ve discussed this issue with VCs and buyout types, the only question they keep asking is, Do you think anything will come of this? The answer seems to be that Congress will take its sweet time with this issue, usually a prescription for inaction.

(Should “carry” be taxed as ordinary income? Have your say in my comment section or in this poll.)