Carried interest, or the percentage of profits equity fund managers and general partners earn for managerial services, is currently taxed at the capital gains rate of 15%. However, proposed revisions to the Internal Revenue Code would classify, and then tax, carried interest as general income – a change that could subject managers to significantly higher income taxes. Advocates of a tax increase contend that carried interest simply represents compensation for services provided, and accordingly, should be taxed as ordinary income. In contrast, opponents of a tax increase claim that carried interest represents an investment of the manager's time, resources and services, subject to a substantial risk of loss, therefore should be taxed in accordance with traditional capital investments.

In our current political climate, many commentators focus their analysis on the "fairness" of a lower or higher tax rate on the carried interest of fund managers. Below the surface, however, are repercussions with greater implications which should also be considered. A 2007 study published by the US Chamber of Commerce indicates that venture-backed capital accounted for $2.3 trillion in revenues, 17.6% of the gross domestic product and 10.4 million private sector jobs based on data from 2006, affecting finance activity in almost every sector of the US economy. Indeed, the outcome of the carried interest debate will not only effect the bank accounts of equity fund managers and general partners, but also investors and portfolio companies, and the United States economy as a whole.

Accordingly, this Alert White Paper serves to highlight certain economic consequences that a change in carried interest tax treatment may generate – both positive and negative.

Unintended Difficulties That Businesses May Face

An Increased Carried Interest Tax Rate Could Reduce The Number Of Private Equity-Funded Businesses.

An increase in the tax rate for carried interest will be treated as a business expense and factor into a fund's targeted return, resulting in a reduction of return on investment (ROI). In addition, funds may spend additional time and resources, and demand greater protections in investment documentation, to counterbalance the reduced ROI. In economic terms, the net impact of increasing the rate from 15% to 35% would reduce the after-tax return of assets by partnerships generally by almost 90 basis points. If the tax cuts of 2003 expire (resulting in an increase in the ordinary income rate to 44%), this number would increase to over 115 basis points. As the market reacts over time, this after-tax return gap could lead to fund restructuring or the redeployment of capital away from lower-return uses, thereby further depressing the prices of private equity assets and causing funds to divest assets, or engage in less "new investment" activity. This could lead to a contraction of private equity-backed businesses.

Smaller funds will be forced to deal with these consequences sooner because of their sensitivity to fluctuations in overhead. This trend could be especially difficult for small funds. Struggling smaller private equity funds could chill the growth of US-based entrepreneurial enterprises, as smaller private equity funds tend to invest in emerging, innovative markets.

Reclassifying Carried Interest Will Likely Impact Limited Partners As Well As The General Partners.

Limited partners may face an increase in fees for the manager's services, and established or potential managers may move out of the private equity arena entirely. In addition, the market may react irrationally in anticipation of bad things to come. As a result, a fund and the businesses it supports may not be able to accurately anticipate risk and may overcompensate or be subject to unanticipated costs as projections become reality. While larger funds may be able to absorb these costs, smaller funds likely do not have the market position to renegotiate agreements with limited partners or find qualified manager replacements. Such funds may be forced to fund fewer deals or shut down entirely.

Reclassifying Carried Interest May Also Affect Entrepreneurs.

Reducing demand could result in a reduction in both the equilibrium price for a company (i.e. a lower multiple paid) and quantity of deals that close, especially for smaller funds. As funding becomes less available, market activity declines, reducing the total amount of capital raised by entrepreneurs. Fewer business ventures will translate into reduced use of managerial talent, lower returns and, compounded with the generally lower investment discussed above, a general depression of market activity.

An Increased Rate Of Taxation May Encourage Foreign Investment Over American Investment.

If a carried interest tax increase becomes a reality, US general partners could face an effective tax rate of 35%. That would rate as the second highest tax rate for such activity worldwide, second only to Denmark (44%). This could result in a decrease in US-based private equity investment, and/or a net increase in foreign investment in US operations – which is clearly not the intended result from a change in carried interest tax policy.

The Practical Realities Of Collecting The New Taxes May Result In Minimal Increases In Tax Revenue.

The reality may be that an increased tax rate on carried interest may not lead to any new tax revenues as partnerships and general partners adapt to the new system. Private equity enterprises will look to plan around a tax increase, including revisions to their capital structures, adoption of loan-based structures with smaller investments, substitutions in potential company fees, co-investment structures or even an abandonment of the partnership structure. In the end, this tax increase could result in nothing more than a departure from the current partnership structures which could damage a functioning system without raising any additional tax revenues. The investor market, however, may not adjust to these changed approaches quickly, leaving the door open for foreign investors and harming entrepreneurs in the mean time.

Benefits To Business From A Change In The Carried Interest Tax Rate

A Change In The System May Incentivize The Development Of New Fund Structures.

Although funds may change to avoid the higher tax consequences, this may be a good thing. Fund sponsors are creative; a tax change may lead to the development of new, more sophisticated structures for private equity capital, which may be even more aligned with entrepreneurial interests.

Other Areas Of The Tax System Will Likely Be Targeted If This Change Is Not Implemented.

Just as partners and investors may look to alternative ways to avoid increases in tax liabilities, lawmakers may look to other "loopholes," particularly those relating to the capital gains tax, for sources of tax revenue. Although it is difficult to predict given that any number of tax provisions could prove potential targets, businesses should expect that avoiding a reclassification of carried interest will likely require another "loophole" to be found and closed, which may have more detrimental public policy consequences.

Conclusion

Whether one agrees with a change in the tax treatment of carried interest or not, it is clear that the implications of such a change include more than just "fairness." As our economy struggles and additional resources are needed in both the government and the market, lawmakers must be both informed and judicious in their actions.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.