It would appear that private equity firms are the virus and tax policy is the vaccine, with both locked in an evolutionary race. President Obama’s 2011 budget suggestions assume that GPs, faced with a higher tax rate on carried interest, will morph their practices to skirt the full impact of the new tax rate.
In the recently released Obama budget’s estimates of how much revenue this tax hike will bring in over the next ten years, one notices that the numbers taper off after 2014: $3.494 billion in 2014, $2.803 billion in 2015, $1.725 in 2016, and so on down to $1.060 billion in 2019.
This taper effect is not based on the expectation that US GPs will earn less in carry, but rather because the Treasury anticipates that private equity firms will gradually find a way around the tax increase, one Treasury official told The Wall Street Journal.
The most common strategy being quietly circulated as to how GPs might soften the blow of carried interest being treated as ordinary income is for GPs to borrow their portion of the equity in a deal from limited partners. Under this approach, any returns on the deal would be considered capital gains. That said, the President suggests increasing the capital gains rate for individuals earning more than $200,000 per year to 20 percent.
But the Treasury official told the Journal that Washington will counter any new tax avoidance strategies with new policies.