It took an unlikely alignment of events to create a situation where venture capitalists and private equity managers could pay a lower tax rate than their secretaries. And it doesn't look like it'll last.
Rep. Sandy Levin (D-Mich.), who's been on a quest to reform the tax rule, told the Huffington Post he's been in touch with the Treasury Department putting the final touches on a bill that will end the practice, bringing at least $25 billion in additional tax revenue.
Levin's efforts coincide with a line item in President Obama's budget which calls for taxing carried interest as ordinary income. The item is creating some consternation on Wall Street and within the Republican Party.
"I'm hopeful," said Levin. "It's not only raising money, the most important issue is equity, fairness. As part of the effort to create fairness in the tax code, this should and will be part of it."
At issue is how the profits from some partnerships are taxed. For example, VC firms, private equity shops, some hedge funds and real estate companies take investor funds and put the money in stocks, start-up companies and buildings, respectively, to make more money. The profit that these partnerships generate is currently treated as long-term capital gains, taxed at a rate of 15 percent, as long as it is held longer than a year.
But critics of the tax rule say the profit isn't capital gains. Rather, the partnerships have provided a service and so the profit is really ordinary income, they say, and so should be taxed at the ordinary income rate of 35 percent.
For Levin, his mission began in 2007, when a law school friend of his who had become a tax lawyer told him about the tax rule. "I came back, talked to the staff and said, 'Scrub this.' After two or three months they came back with their conclusion that it was unjustifiable," said Levin, a subcommittee chairman on the Ways and Means Committee, which handles tax policy. His bill passed the House but died in the closely divided Senate.
While the Obama administration has not revealed much about its plan to change the tax rule, the budget item comes with a $2.5 billion revenue forecast, suggesting the change would be sweeping, said Joel Scharfstein, a tax partner at the law firm Fried Frank. "At this point, it is just a line item, and we haven't heard too much more, but I am assuming that the Levin bill will be a starting point," he said.
How did such a lopsided policy ever take hold? The rule on carried interest was established in 1954, when a large set of the tax code was codified. It was never much of a problem because most partnerships were small factories or other businesses that produced tangible products, so any profit was taxed as ordinary income.
This changed as complex financial firms began making profits off of intangible products like stock investments, and began claiming long-term capital gains regularly.
President Clinton fueled the trend when he cut the capital gains tax in 1997 from 28 percent to 20 percent. With the highest tax bracket for ordinary income at 39.6 percent, it meant financial firms that had been looking at an 11.6-percentage-point spread, now had a 19.6-percentage-point differential.
A Clinton official said that when the rate was cut, no one in the administration foresaw that it could impact private-equity compensation like it has.
Then, in 2003, President Bush slashed the rate down to 15 percent and the top rate to 35 percent, giving managers an extra five points they could shave from their tax bill if they could count income as capital gains.
"Everybody started saying, 'Lets structure everything we can to generate capital gains on an ongoing, ordinary basis,'" said Clinton Stretch, a principal at Deloitte Tax. "The point was to just generate capital gains."
Defenders of the loophole argue that the tax rule encourages capital investment, and is a long-accepted practice. Because the VCs and others put in so-called "sweat equity" -- working hard to create a profit -- it is capital gains, these people say.
"You can have a good academic argument about the definition of income, about whether or not they should claim this as ordinary or as capital income because they put sweat equity into it," said Rep. Paul Ryan of Wisconsin, a leading voice for Republicans on economic issues. "There's a longstanding tradition that if you put a dollar of investment in, then you're a part investor and you can split the proceeds of the investment based on any factor you want to. Then, it ought to be cap gains and that's a pretty widely understood theory."
Especially in an economic downturn, changing the rules makes little sense, according to critics. Firms aren't making as much profit anyway, and it "will definitely put a damper on entrepreneurship," said a tax partner at Sadis & Goldberg, Roger Lorence.
Rep. Ryan added: "Most people think, let's just go get these big bad Wall Street guys. But the question is, what kind of ramifications will this have on Main Street people and small businesses?"
Still, Levin argues that Wall Street financiers would continue receive the more favorable 15 percent rate if they invest their own money into a partnership. Small businesses, he said, will be specifically addressed in a separate bill. "To the extent they've invested their own money, they pay a capital gain. To the extent they're managing other people's money, they pay ordinary income tax like everybody else who is managing other people's funds," he said.