TAX NEWS - June 2010

A Stealth Attack on Capital Gains

Buried in a Senate bill to extend health coverage to Americans struggling through the recession is a provision that would upend decades of established partnership law. It would single out particular types of businesses and penalize the entrepreneurs who have built them from scratch.

Under the provision, the sale of any business that qualifies as an "investment services partnership" would no longer be treated as a long-term capital gain, but instead be subject to taxation at ordinary income rates. Included in this definition are hedge funds, and private equity firms, as well as firms that manage venture capital and real-estate investments. Essentially, Congress has decided to target a select group of entrepreneurs in an industry that is unpopular.

This new, higher "enterprise value tax" is not part of the contentious debate over the taxation of "carried interest." It is true that the Senate bill also would eliminate capital gains tax treatment for carried interest—which is the name for an accounting practice that's used to distribute revenue to the general partners in certain kinds of partnerships. Carried interest, however, has nothing to do with the sale of a business. Nevertheless, policy makers eager to raise revenue have tried to obscure the distinction between the two.

Congressional tax writers realize that increasing the tax on carried interest won't raise the $112 billion needed to cover other programs in the Senate bill. Thus they propose that any equity owner in an investment services partnership that has received even one dollar of carried interest can no longer sell his share of the business at the traditional long-term capital gains rate. The result of this intricate tax policy maneuvering is that the enterprise value tax would generate the lion's share, approximately two-thirds, of the revenue raised by what has been billed by tax writers as "closing the loophole on carried interest."

Embedding the enterprise value tax, which has not been subject to public debate, into the carried interest proposal represents a stealth attack on the capital gains tax. It also represents a dangerous precedent for any other business or industry that finds itself unpopular with politicians or the public down the road.

In recent years, no sector of the financial services industry has been cast in the role of shadowy villains more than hedge funds. Yet hedge funds were not the drivers of the financial and credit-market crisis. They did not take, nor did they seek, taxpayer money in the aftermath. At the height of the crisis in the credit markets, the Obama administration publicly called upon those in the "private investment" community to assist and support government rescue efforts. Hedge funds responded by participating in the government-run TALF program, making direct loans to various businesses and investing in renewable energy companies.

Hedge funds employ tens of thousands of Americans, and play a vital role injecting capital into the markets, enabling large and small publicly traded companies to hire more workers and expand their operations. More than 70% of the assets managed by hedge funds are owned by pension funds, endowments and non-profit foundations.

Last week's Wall Street Journal noted that in a volatile 2010, the average hedge fund has gained 1.3% year-to-date, while the S&P 500 index has lost over 3% of its value. Over the last 10 years, the Hennessee Hedge Fund Index posted cumulative gains of 88% while the S&P 500 lost 23%.

Nevertheless, the enterprise value tax pending before Congress would strip partners and founders of hedge funds and other investment partnerships of their ability to sell their business or stake on the same terms as every other business owner in this country. This is punitive and discriminatory.

The proposal to increase taxes on investment services partnerships by capitalizing on negative public stereotypes would undermine our economy during a period when government should be promoting measures that encourage growth. It establishes a business caste system, tiered and separated into those businesses that Congress—for the moment—judges as "good" and "worthy" of favorable tax treatment, and those considered mere fodder to finance their spending priorities.