Tax fears rile US private equity market

Partnership tax specialists are being besieged by client requests for information amid fears that the US Congress may propose a big hike in the tax rate applied to carried interest, according to legal sources.

A tax law specialist in New York who works with private equity firms said “this week has been a big rumor week” among his clients. Another lawyer said approximately one-third of his email traffic today has been from clients asking about the supposed tax proposal.

The fears follow client memos from two law firms, both of which suggested the firms have received indications from congressional staff that US lawmakers are studying carried interest as a potential source of further tax revenue. Sources characterized these indications as both informal and indirect.

A March 6 memo from law firm Paul, Weiss, Rifkind, Wharton & Garrison described tax proposals being considered and developed by the Senate Finance Committee. The memo noted: “Significant consideration is also being given to carried interest issues, with the focus being whether to characterize that income as compensation for services and not as long-term capital gains.”

Long-term capital gains in the US are currently taxed at 15 percent, while ordinary income is taxed at a rate of up to a 35 percent.

The memo continued: “We also expect other proposals to emerge in the future, most of which will focus on whether various types of income are properly characterized as ordinary income or capital gain.”

A memo sent out yesterday by New York law firm Debevoise & Plimpton read: “We understand that legislation may be proposed that would target the taxation of carried interest arrangements and so-called ‘management fee deferral mechanisms’ (i.e. possibly disqualify the carried interest from the favorable 15% capital gain rate).”

The Debevoise memo noted that the firm had no additional details about the developments, and that it is “impossible to anticipate whether any such legislation would actually be enacted or in what form”.

A separate legal source said he was aware of industry discussion surrounding potential tax legislation, including the potential recharacterization of carried interest as ordinary income. “That would be horrible,” the source said, adding he could not confirm this potential proposal.

The second area of discussion has to do with management fee offset structures (noted in the Debevoise memo), whereby GPs apply their shares of the management fee value to their fund capital accounts for long-term appreciation.

The third area has already been unveiled by Congress – the creation of a 20 percent penalty on certain forms of deferred compensation. This proposal is expected to affect certain hedge funds, but not affect most private equity partnerships, according to a legal source.

Commenting on the fears he sees rippling through the market, a legal source said: “I’ve been doing this a long time, and this is one of the more bizarre episodes I’ve witnessed.”

A separate source said fears of impending changes to carried interest taxation are “unfounded” and overblown, given the scarce information available about such potential legislation.