Curtains for Carried Interest?

For those who didn’t catch it, The Wall Street Journal recently reminded managers of hedge funds, venture capital funds and private equity funds that their precious “carried interest” is once again in President Obama’s cross-hairs.

The President’s last three annual budgets have proposed taxing carried interest as ordinary income at rates of up to 35%, but, each time, the measure was stymied in Congress. Carried interest has traditionally been taxed in the U.S. at long-term capital gains rates which, since 2003, have been capped at just 15%. LTCGRs were not always as low as they are today, but they have never been as high as ordinary income rates. In the mid-‘70s, for example, the top LTCGR was 40%, which was still well below the maximum ordinary income tax rate of 70% at the time.

Carried interest is the share of investment profits that private fund managers earn in addition to their asset-based management fees. It has gotten preferential tax treatment on the ground that it represents the ‘sweat-equity’ interest of private fund managers in the returns on their portfolios. ‘Carry’ also feels more like an equity investment than wages because it is contingent on future profits.

Opponents of the tax preference charge that ‘carry’ is nothing other than a management fee disguised as an equity interest. Fund managers earn it from their investment services and not from capital contributions.

Thanks to the low effective tax rates paid by the likes of Warren Buffett (see Zingers from Buffett, Welch and Weill) and Obama’s resounding populist victory over Mitt Romney, the President probably has all the political ammunition he now needs to finally shoot down the controversial tax preference that for so long enriched his game but unsuccessful challenger.