Selling stakes to cost more?

The recently passed US House bill that would raise taxes on carried interest includes an overlooked provision that would make general partners pay ordinary income tax on profits from selling a stake in their own management companies.

The provision is intended to keep private equity executives from circumventing the higher taxes on carried interest imposed by the bill passed by the US House 28 May, said a spokesman for the House Ways and Means Committee in a statement. Without the provision, fund managers would sell their stakes and pay the lower tax rate, just before receiving income subject to higher taxes, he said.

The bill, known as the American Jobs and Closing Tax Loopholes Act of 2010, now goes to the Senate, which returns from the Memorial Day recess 7 June.

Law firms are increasingly hearing about the provision from anxious GPs.

“You essentially have a double whammy. If you hold the interest, you are going to be subject to taxes and that would depress the value of the business. If you’re selling the business as a whole, that will also be ordinary income,” said James Nix, a New York-based partner at Dechert.

Private equity lobbyists made a late push against a House vote last week highlighting the management sale provision, which prompted some observers to wonder if the provision was added just before the vote was set to take place 27 May.

“This isn’t a new provision, it’s just been overlooked,” said Nix.

Lobbyists were in an uproar. “This bill would make investment partnerships the only businesses in America whose owners would be ineligible for long-term capital-gains treatment” when they sell their stake in a firm, said Douglas Lowenstein, president of the Private Equity Council.

Lawyers, however, do not anticipate a drop in investment.

“If a firm is successful, and GPs are still taking a piece of the profits, there will still be interest in the industry. I think you may see a further ‘weeding out’ of the weaker firms, but there will still continue to be interest in private equity and venture,” said Craig Miller, a San Francisco-based partner at Manatt, Phelps & Phillips.

The provision could cause GPs to ask for a higher percentage of carried interest.

“The overall impact of this is a potential reallocation between the economic split between LPs and GPs,” said Miller. “I think LPs will be somewhat responsive. I don’t think it will be dollar for dollar, but there will be recognition that a slight increase in GPs carry will be appropriate. And stronger funds will be able to have more leverage.”

The House has voted three times in three years to pass carried interest tax hikes only to see the legislature stall in the Senate. If the Senate passes its version, the two will be reconciled in committee before being signed into law.

Lobbyists are hopeful the provision and the bill are struck down in the Senate.

“We hope the Senate will consider carried interest options that still raise considerable revenue without discouraging important investment activity. They have the opportunity to support economic growth and innovation in their states, and throughout the country. Let's hope they seize it,” said Marc Heesen, president of the National Venture Capital Association.