06/11/2013 04:55 pm ET Updated Aug 11, 2013

How Likely Is Carried Interest Reform?

During the height of the financial meltdown in 2009, Congress became obsessed with changing the tax treatment of carried interest. The idea that wealthy hedge fund managers could receive preferential capital gains treatment on their carried interest income shocked Democrats, and the media ran several stories that seemed to create public furor over the inequity. Carried interest legislation actually passed Nancy Pelosi's House but fell apart in the Senate when Finance Committee Chair Max Baucus, D-Mont., expressed reservations. Despite practitioner fears and the IRS's belief that legislation was imminent, carried interest reform hasn't gotten close since. But that may finally be changing.

Carried interest is taxed under capital gains rates because of Rev. Proc. 93-27, 1993-2 C.B. 343, which states that the IRS will not tax the issuance of a profits interest. (That is a simplification of a complex issue, but a correct one.) Hamstrung by its longstanding administrative position, the Service doesn't believe it can change the tax treatment of carried interest without new legislation. Practitioners have never been completely convinced that it would take a new law for the carried interest party to come to a close. They frequently press the IRS for reassurance that the rule won't be changed absent a new law and they almost always get it.

Whether the IRS is right about its ability to administratively change the tax treatment of carried interest isn't that important. It's going to take an act of Congress. But if carried interest reform legislation couldn't make it out of a Democratic Congress in the midst of a recession that was blamed on the financial sector, is there really any chance of it becoming law now? The answer, surprisingly, is yes.

The prospects for carried interest reform have changed. The IRS has long been delaying any administrative action in the area because it believed Congress could pass a law at any moment. While that didn't seem likely, it was always possible. (Remember economic substance codification? No one thought that was likely to pass until it suddenly did.) Now the thinking on Capitol Hill might be shifting. The Senate Finance Committee recently released its eighth tax reform discussion paper, and changing the tax treatment of carried interest was front and center. The Finance Committee paper is important because Baucus's opposition to carried interest reform is what killed it during the height of Democratic legislative power.

House Ways and Means Chair Dave Camp, R-Mich., has said that everything is on the table and wouldn't deny that his tax reform plan might alter the taxation of carried interest. Carried interest can be an attractive pay-for. Some estimates say it would raise $30 billion over 10 years, which could be used to pay for sweeteners that affect a much larger bloc of the taxpaying public (like, say, homeowners, who want to keep the mortgage interest deduction off the table).

There is a lot of misinformation out there about carried interest, what it represents, and who would be hurt by taxing it at ordinary rates. The fact is that under the current legislative proposals (which would tax only a portion of carried interest compensation at ordinary rates), almost no one outside the hedge fund industry would be harmed. There wouldn't be any less capital available for investment. There wouldn't be a sudden withdrawal of hedge fund managers from the industry (would that really be such a bad thing for the economy?). Nothing would change but an inequitable tax policy that the IRS administratively created to benefit only a small class of very wealthy taxpayers.

Carried interest reform will almost certainly be part of any major tax reform bill offered by Camp or Baucus. But it's also possible that even if tax reform efforts fail or stall, carried interest legislation could find its way into an extenders package or as a pay-for for deficit reduction or an extension of the debt limit. As Republican and conservative Democratic resistance has waned, the prospects for a change in carried interest rules has increased. And, frankly, it's about time.

Jeremy Scott is editor of Tax Analysts' Tax Notes magazine. He also blogs at