Private equity investors were stunned last week when Senators Joe Manchin and Chuck Schumer agreed to a massive reconciliation bill. Not only did Manchin go yes on anything, but he adopted very convoluted language about changing the tax treatment of carried interest.
The big picture: This could become an act of full employment for private equity fund accountants.
What to know: We still don’t have the full legislative text of Manchin’s bill, with Senate Democrats providing only a one-page summary instead. But many sources say the wear change will be spelled out by the House version of Build Back Better (RIP).
- It does not characterize carried interest as ordinary income, which everyone agrees would be the cleanest way to close the loophole (even among those who cringe at the suggestion that it is a loophole).
- Instead, it focuses on retention periods. First by extending the minimum holding period for treatment of capital gains on PE interest from three years to five years. Second, by starting the clock on the later of the date the fund acquired “substantially all” of its transferred interests or the date it acquired “substantially all” of its assets.
Here’s the problem, as explained by the law firm Gibson Dunn: “The law does not specify how the “substantially all” requirement should be measured, and because many investment funds (eg, hedge funds and equity funds) acquire assets at different time and have overlapping holding periods, it would be extremely difficult for taxpayers to determine when these requirements have been met.”
- Additionally, the language also creates the wrong incentives for PE investors by creating different minimum holding times for different portfolio companies within the same fund.
- House Democrats are said to have been working to fix the BBB language until Manchin and Sen. Kirsten Sinema torpedoed the entire package. But nothing was ever codified, so the new plan is the same as the old plan.
- “Congress needs to provide more guidance on what they intend to pay fund managers,” a private equity lawyer tells me. “Otherwise you get a free for all, because no one can figure it out.”
Wildcard: It’s still very possible Sinema will again refuse to play ball or insist on dropping tax provisions like carryovers and corporate minimums. Axios’ Alayna Treene reported more on her thinking last night.
- The American Investment Council, a PE lobby group, notes that there are nearly 150 private equity firms based in Arizona, plus 678 PE-backed portfolio companies that employ 229,000 Arizonans.
Savings: Senate Democrats say their carry tax changes could generate $14 billion over 10 years. Pretty impressive. Not the number per se, but that someone felt comfortable calculating a number given the legislative ambiguity.
- It’s also worth noting that $14 billion is the same figure CBO used in 2019 for a proposal that would treat carryovers as ordinary income. Certainly, the near-term outlook for PE earnings was slightly stronger in 2019 than in 2022.
The bottom line: The political debate over the taxation of carried interest began more than a decade ago. It’s no less messy today than it was back then.
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