Carried interest provision gains momentum as Democratic leaders approach deal on extenders offsets

Changes to the tax treatment of carried interest income have dominated discussions in recent days as House and Senate negotiators are reportedly nearing an agreement on how to pay for legislation that would extend dozens of expired and expiring tax provisions such as the research and experimentation tax credit, the New Markets Tax Credit, 15-year straightline cost recovery for qualified leasehold improvements, the exception for active financing income under subpart F, and lookthrough treatment of payments between related controlled foreign corporations.

House Ways and Means Committee Chairman Sander Levin, D-Mich., told reporters May 11 that a bill could be ready for House floor action as early as the week of May 17, bypassing a Ways and Means markup. Levin and Senate Finance Committee Chairman Max Baucus, D-Mont., maintain that they would like to send a final extenders package to the president by the Memorial Day recess.

Leaders in both chambers have been on the hunt for revenue raising options since some of the original offsets included in their respective extenders bills, passed in late 2009 by the House and in March by the Senate, were siphoned off to pay for other legislation. The current extenders package, now called the Promoting American Jobs, Closing Tax Loopholes, and Preventing Outsourcing Act, is expected to cost roughly $50 billion.


Phase-ins, but no exemptions, Levin says

According to Levin, the bill will include as its core revenue offset a provision to tax income from carried interests as ordinary income rather than capital gain. The provision will include a phase-in period, Levin explained, and the top tax rate on carried interest income will eventually equal the top individual marginal income tax rate.

The provision will not include exemptions for taxpayers in specific industries, Levin said.

The extenders bill approved by the House late last year included a similar provision – but without a phase-in – that the Joint Committee on Taxation (JCT) staff has estimated would raise $24.6 billion over 10 years.

Reservations in the Senate – Previous attempts to modify the treatment of carried interest income have failed in the Senate, but Finance Committee Chairman Baucus indicated May 12 that a change is "probably going to happen." Still, pockets of resistance to the emerging deal remain. In a May 11 letter to Baucus and Finance Committee ranking Republican Charles Grassley of Iowa, a bipartisan contingent of senators asked that venture capital firms be exempted from the proposal. The group – which includes Democrats Robert Casey of Pennsylvania, Jeanne Shaheen of New Hampshire, Patty Murray of Washington, and Mark Warner of Virginia, plus Republican Scott Brown of Massachusetts – argued that profits of venture capital firms should be taxed at current capital gain rates, and that a tax increase would mean that "fewer
venture funds will be created and therefore fewer new companies formed."

For his part, Senate taxwriter John Kerry, D-Mass., has proposed taxing venture capital firms at a rate at the midpoint between the 15 percent capital gains rate and the top ordinary individual income tax rate.


Oil spill excise tax & other possible offsets

A potential new addition to the extenders offset list is an Obama administration proposal announced May 12 that would increase the tax that oil companies pay to finance the Oil Spill Liability Trust Fund from 8 cents per barrel (per 42 gallons) to 9 cents per barrel starting this year, with an additional one-cent hike in 2017. The proposal, which is part of a larger package that the White House unveiled in response to the recent oil spill in the Gulf of Mexico, is estimated to raise approximately $5 billion over 10 years. Congressional Democrats are reportedly looking into an even larger increase in the tax rate.

Foreign tax credit splitting – Still in the mix is a proposal in the Obama administration's FY 2011 budget for a matching rule that would prevent the separation of foreign taxes from associated income.

According to a Treasury Department explanation, the administration's proposal would allow a credit for foreign taxes "when and to the extent the associated foreign income is subject to U.S. tax in the hands of the taxpayer claiming the credit." The provision would be effective in 2011 and, according to the Joint Committee on Taxation (JCT) staff, would raise an estimated $9.5 billion over 10 years.

S corp provisions – Also staying on the list of potential offsets is the imposition of payroll taxes on service-sector S corporations. No specific proposal has been released, but a comprehensive tax reform bill unveiled in 2007 by then-Ways and Means Chairman Charles Rangel, D-N.Y., would subject S corporation shareholder employees to self-employment tax on their S corporation distributive share that relates to the provision of services. Conforming changes also would apply to limited partner employees of service partnerships engaged in services. A similar proposal was recommended in January 2005 by the JCT staff as one of many options for narrowing the tax gap. The JCT staff estimated that the Rangel provision would raise an estimated $9.4 billion over 10 years.


Estate tax proposal almost ready for prime time

In other developments, Senate Finance Committee member John Kyl, R-Ariz., said May 11 that an agreement on restructuring the estate tax, negotiated with fellow taxwriter Blanche Lincoln, D-Ark., and Finance Chairman Baucus, is close to completion. Although specifics of the deal are scarce, Lincoln and Kyl have previously proposed a 35 percent top tax rate and an exemption of $5 million per spouse. Under current law, the estate tax is repealed for 2010 and is scheduled to return in 2011 with a top rate of 55 percent and an exemption of $1 million.

Kyl also indicated that negotiators agree "on many of the offsets," but provided no details. Congressional pay-as-you-go legislation enacted earlier this year carved out an unpaid-for extension of the estate tax at 2009 levels – a 45 percent top rate, with a $3.5 million exemption per spouse – for two years. To comply with the pay-as-you-go rules, a more generous bill – one with a lower rate, higher exemption amount, or longer term, for example – would have to offset any costs beyond that threshold.)

Retroactivity, legislative vehicle uncertain – Although Baucus indicated earlier this year that he intended to make an estate tax fix retroactive to January 1, Kyl stated on May 12 that negotiators are thinking about allowing estates of decedents dying in 2010 to elect to be taxed under the new regime in place for 2011 or under the law in effect at the time of death.

The legislative vehicle for estate tax reform also remains uncertain. Talk of attaching an estate tax fix to small-business tax legislation that the Senate intends to take up before Memorial Day appears to have subsided. Senate aides have suggested taxwriters may choose to combine estate tax legislation with a larger measure that would also address the expiring 2001 and 2003 tax cuts later this year. Congress is expected to make permanent the tax cuts for lower- and middle-income taxpayers, and allow others to expire, but legislation has not yet been introduced.