Tax fail: Carried interest debate (really) is over

December 6, 2010, 8:09 PM UTC

On November 5, 2008, I wrote a column titled: “The Carried Interest Debate Is Over.” Here was my lead:

Remember that big debate over how the IRS should treat carried interest, in which certain agitators (hello mirror) argued that such profits more closely resemble ordinary income than capital gains? Well, it effectively ended last night at 11pm ET, when Barack Obama corralled his 270th electoral vote.

Momentum for such a change stalled late last year, due largely to vocal opposition from President Bush and GOP Congressman Tom Reynolds. It also didn’t hurt that private equity was wiped off the front pages by credit concerns, but this was more about political power than political posturing.

Now, however, the playing field has been dramatically altered. Bush will be replaced by Obama, who signaled 18 months ago that he supports a change to carried interest tax treatment. The retiring Reynolds will be succeeded by another Republican (Chris Lee), but not by one with nearly the same seniority or influence. Plus, the Democrats will have much stronger majorities in both houses of Congress.

The response was swift and, in some cases, furious. One prominent industry lobbyist screamed via telephone that I had “no idea what I was talking about…” and that such projections were “irresponsible.”

Turns out he was right. I was wrong.

The Senate today will vote on a tax cut extension bill that no longer includes the carried interest provision. There is still a small chance that the change will reemerge in whatever grand bargain is struck between Obama and Republicans, or perhaps next year if/when real tax code reform is broached. But don’t bet on it, since most House Republicans have metastasized around the idea that any tax hike – even if it’s closing a loophole or being matched by spending cuts – is a non-starter (as such, also don’t expect real tax code reform).

I am humbled by my poor prediction. My fatal flaw was in badly underestimating the cowardice and incompetence of Congressional Democrats.

This was a no-brainer. It would have taxed private equity investors the same way the rest of us are taxed: Ordinary income rates on fees for service, capital gains rates on money that we ourselves have put at risk via investment.

But somehow Democrats were bullied by industry arguments that this was class warfare, or that private equity investment – and VC investment, in particular – would dry up. Never mind that not a single PE or VC investor of significance threatened to retire were the change exacted. Never mind that VC investment totals were higher when capital gains rates were higher. Never mind the intrinsic inequity of the current construct.

Never mind any of it. Because now the carried interest debate is over. For real this time.