A three-year battle over how the federal government taxes investment partnerships is coming to a head, after Senate Democrats unveiled a proposal that would more than double the taxes on private-equity, hedge-fund and certain real-estate managers.
The move is the strongest indication yet that financiers will pay higher taxes to help close an expanding U.S. budget gap. Congress is taking aim at the perceived excesses of the financial-services industry, but the proposed changes have implications well beyond Wall Street.
The proposed law would tax "carried-interest" income, or the share of profits that fund managers receive as part of their compensation. This income is currently taxed at a 15% rate, while the ordinary income by most wage earners is taxed at up to 35%. The new law would raise the tax rate for partnership income to an effective 30% in 2011 and 33% in 2013.
Those sponsoring the bill say the proposed measure rights a fundamental unfairness in the tax code. Lawmakers say that the people running partnerships have been paying capital-gains rates on what were basically wages.
Opponents of the bill say it will discourage investments needed to create growth and jobs. Douglas Lowenstein, president of the Private Equity Council, an industry trade group, says carried interest is properly recognized as a capital gain because "earning carried interest involves taking risks, making long-term investments and exposing yourself to the possibility that you'll have to return your earnings if things don't work out," he said. "No one who gets a paycheck has to face those consequences."
The Senate plan — slightly milder than a House bill passed last week — also includes what is known as an "enterprise-value tax" provision. It would tax the sale of a private-equity firm, hedge fund and real-estate partnership at higher rates. The new measure seeks to impose higher taxes on lucrative transactions, such as Blackstone Group's initial public offering in 2007.
The taxes are part of a broader bill, co-sponsored by Rep. Sander Levin (D-Mich.) and Max Baucus (D-Mont.), to extend jobless benefits and boost infrastructure programs in an effort its backers say will stimulate the economy. Lawmakers are seeking to raise tax revenues to pay for these initiatives, and the tax increase on carried interest is expected to raise $14.5 billion over 10 years.
A vote on the bill isn't expected until next week, leaving room for last-minute horse-trading. Still, there is a growing expectation on Capitol Hill that a version will pass, showing how sentiment has shifted in Washington. The financial industry had blocked similar bills several times in the past three years.
Industry executives continued to attack the plan, swarming Capitol Hill to make their case. Stephen Schwarzman, the chief executive of Blackstone, and Leon Black, head of Apollo Global Management, were in Washington Monday and Tuesday meeting with lawmakers.
The section of the bill that most rankles financiers is the enterprise-value tax. Lawyers and lobbyists for investment-management partnerships describe the provision as punitive and having no precedent. The sale of a grocery store, manufacturer or bank would still be taxed at lower capital-gains rates.
Matthew Beck, spokesman for the House Ways & Means Committee, said the enterprise value tax provision "does not represent a change of basic philosophy about the taxation of partnership sales." He said the House had no plans to impose the tax on other partnerships beyond those specified.
The tax changes would have a stiff impact on real-estate investors who manage or advise partnerships. There are about 1.2 million partnerships in the U.S., investing in everything from land to office buildings to shopping centers.
"It is impossible to understand how more than doubling the tax on real-estate activities will encourage any new business, put anyone back to work in construction, or shore up property values to help dig local budgets out of their deep holes," said Jeffrey DeBoer, chief executive of the Real Estate Roundtable, an industry trade group.
Not all partnerships are getting hit by the Senate bill. For example, some publicly traded oil and gas partnerships avoided several of the more onerous requirements of the carried-interest provision.
Some believe the proposed tax is in reaction to a perception that deals using anomalies in the tax code reaped extraordinary benefits. Mr. Beck of House Ways & Means said lawmakers were unhappy over the 2007 Blackstone IPO. It generated $2.6 billion in cash proceeds for its top three individual shareholders — Mr. Schwarzman, co-founder Pete Peterson and firm president Hamilton James. Some experts have argued that the current code allowed the selling partners in effect to recoup a large portion of their own taxes on the deal.
"There was no tax loophole used in the Blackstone IPO. No partner received a dime in tax credits or tax refunds," said Blackstone spokesman Peter Rose, who estimated that Blackstone partners will pay more than $900 million in taxes on the deal.
Another little-noticed change in the Senate proposal could in 10 years effectively force publicly traded partnerships such as Blackstone and Fortress Investment Group to change their structure, and either cease being publicly traded or face taxation as corporations.