TAX NEWS - June 2010

US Tax: Vigilantes Out To 'Get' Equity Firms Will String Up Tax Policy In Process

Congress is in a hurry, and when that happens we should all be nervous about the potential for unintended consequences from rash action.

In the next few weeks both an "Extenders" bill related to taxation and a Financial Regulation bill will be considered. Both bills have the potential for some serious policy miscues. But as it happens, where the two topics overlap, a veritable poster child of hastily designed bad policy is emerging.

The tax extenders bill has a number of popular short-term provisions which are being paid for with permanent tax increases. And now that the Congressional Budget Office has determined that the Financial Regulation bill raises the deficit, the push will be on to find even more ways to raise revenue.

One area of overlap that has been singled out for more taxes is carried interest, which represents the return on the investment that various investment partnerships receive if the projects they oversee prove successful. Frankly, there is a case to be made for raising taxes on carried interest by taxing it at regular tax rates. There is also a case for the current tax treatment of that type of income as capital gains.

Legislation that passed the House, but not yet approved by the Senate, would split the difference between these arguments by creating a blended rate that is 75% regular tax and 25% capital gains. That is the stuff of political compromise, which doesn't make a lot of policy sense and would create yet more complexity. It is part and parcel of how tax bills are written.

But the bill goes further than that in a way that causes serious harm to our tax system by broadening the reach of this new blended rate to things that bear no resemblance to carried interest. The provision under consideration makes absolutely no policy sense and seriously undermines some long standing principles of tax policy.

The only rationale for what is being done is political: to "get" private equity firms and those who invest in them. This is vigilante justice logic coming to tax policy, and walking down that road will create serious problems in the long term for our system of taxation.

What the bill does is tax all of the proceeds from the sale of an investment firm or partnership at ordinary rates if it ever received a single dollar of carried interest. Most investment partnerships diversify their investments into a wide variety of areas, so it would not be unusual for them to receive, or to have received, some income in this form. This proposed treatment violates two fundamental principles of sound tax policy.

First, sound tax policy holds that income from a given source should be treated the same across all taxpayers.

This is a basic principle of tax equity. But, under this proposal the retained earnings and goodwill built up over the years in one firm would be taxed at capital gains rates when the firm is sold — but that same income would be taxed at ordinary rates in another, otherwise identical firm, which happened to receive some carried interest at some point in its history.

Second, sound tax policy should minimize possible retroactive effects. This is to facilitate sound business planning.

Suppose, for example, that Congress decided to raise taxes on farming. It could do so and individuals would be free to decide whether or not they wanted to be farmers under the new tax law. It would be quite a different matter for Congress to rule that anyone who had ever received farm income would be asked to pay an extra tax on all future income from any source whether or not they still went on farming. But, that is effectively what this proposed treatment of carried interest does.

Violation of the basic principles of tax equity and retroactivity opens a Pandora's box of possible tax rules that would make a hash of our current tax system and destroy the capacity for rational business and financial planning.

Fixing the problem would be quite straightforward. Only the portion of any profit from the sale of an asset that is attributable to carried interest should be subject to the new tax treatment of carried interest while income from other sources should be treated as under current law.

With the economy recovering only slowly and the financial system still fragile, this is not the time for reckless experiments in either tax or regulatory policy. Scoring political points by trying to "get somebody" who is unpopular may make short term political sense, but it will undermines the legal foundations on which our economy is based. This will mean less economic growth, fewer jobs, and lower living standards.

Congress needs to slow down and think carefully about what it is doing before passing either the Financial Regulatory reform bill or new tax legislation.

Lindsey, former assistant to President George W. Bush on economic policy, is president and CEO of the Lindsey Group and author of "What a President Should Know ... But Most Learn Too Late."