Industry lobbyists have cautioned that changing the tax treatment of carried interest could have negative consequences for general partners, many of whom are preparing for the worst.
Some private equity and real estate fund managers are requesting terms that would allow for the renegotiation of limited partner fund agreements in the event carry loses its capital gains status – and is instead treated as ordinary income.
Though uncommon, the development indicates that some fund managers are bracing for what could be a difficult transition in the event taxes do go up, sources told sister publication Private Equity International.
“When carry legislation proposals surfaced some years ago, some GPs — not knowing what form the legislation ultimately would take — negotiated provisions in their partnership agreements that said they could modify the agreements to deal with the legislation,” said Michael Harrell of Debevoise & Plimpton, adding that the terms vary in severity depending on the fund manager.
Some GPs negotiated very aggressive language that said they could amend the agreement to minimise the impact of the change in tax law on their economics, he said. But most provisions soften that language by adding that no change can be made if it would adversely affect the LPs.
Unfortunately for fund managers, sophisticated investors are unlikely to grant such a request.
“Like the rest of us, they have to deal with the taxes as they come,” one public pension official told PEI. “I don’t think those would be terms that investors who have the downtown lawyers would go for.”
“They are not going to get those terms from us,” said another, adding that his pension system had not encountered such a request.
Even if carry’s tax treatment were to change, it is unclear how it would do so. Until there is clarity, don’t expect LPs to allow for renegotiation on terms, Institutional Limited Partners Association executive director Kathy Jeramaz-Larson said.
“LPs really are unable to include a term like that in their documents because it’s negotiating a hypothetical, and that’s impossible to do,” she said. “It’s not new necessarily; it’s been around since the issue of capital gains came up a couple of years ago.”
GPs began requesting these terms a few years ago, shortly after Congress began to consider changing carry’s tax treatment to that of ordinary income, which is taxed as high as 35 percent, sources said. One 2010 proposal to tax up to 75 percent of carried interest as regular income was dropped from a US Senate bill. Other proposals have been even more extreme, taxing carry as income in its entirety, though none have managed to make it through both houses of Congress.
However, as more lawmakers become more concerned with the government’s rising deficits, Congress may consider an adjustment to carried interest’s tax treatment as one way to generate more revenue. Between the expiration of Bush-era tax breaks and hundreds of millions of scheduled budget cuts on the horizon, the status of carried interest’s tax treatment has become less certain.
President Barack Obama’s position on the issue is quite clear – each of his last two federal budget proposals stated his intention to close the carried interest ‘loophole’. Although Republicans have successfully opposed those measures so far, recent comments from prominent GOP congressman Rep. Darrell Issa may signify a softening in the party’s stance on the issue, which is not expected to be decided upon until after the election in November.
Republican candidate Mitt Romney, the former leader of private equity firm Bain Capital, has not issued a definitive statement on the matter.
Additional reporting by Nicholas Donato