As we have previously reported, Congress has been seriously considering proposals to change the tax treatment of carried interest. The proposals generated contentious debate in the spring and early summer, and the issue remains far from settled. But the changes have stalled for now, after Senate leadership removed a bill from consideration in late June.

Currently taxed at the preferential rates available for capital gains, new legislation would tax carried interest in a more complex way. If carried interest arises from a return on capital invested by the fund manager, it will continue to be taxed at capital gains rates, in a manner analogous to the taxation of limited partners' gains. But to the extent that carried interest does not reflect a return on invested capital, the proposals would require investment fund managers to treat some percentage of the remaining carried interest as ordinary income. Although this treatment differs from straight ordinary income, it would still have the effect of substantially increasing the effective tax rate on carried interest received by VC fund managers.  This could substantially reduce venture capital activity in the United States, and particularly limit formation of smaller funds that cannot produce excess income through their management fees. 

As the legislative language was being negotiated between the leadership of the House Ways and Means and Senate Finance committees, CDVCA worked with NASBIC to draft an exception to the carried interest change. Our proposal would have exempted interests in SBICs, certified CDFIS, NMVCCs, RBICs, or any other funds “designed primarily to promote the public welfare” from the new treatment. This would have copied the approach taken in the carve-out from the Volcker Rule, as part of the financial regulatory reform legislation. Unfortunately, House leadership, including Ways and Means Chair Sander Levin (D-MI) pledged to avoid any carve-outs from the change. On May 28th, the House passed H.R. 4213, the American Jobs and Closing Tax Loopholes Act, by a slim margin. The bill changes the taxation of carried interest to 75% ordinary income and 25% capital gains.

After several weeks of contentious debate in the Senate, Democrats had settled on a version that would tax carry at 50% ordinary income and 50% capital gain in 2011 and 2012. Following that, carried interest would be 75% ordinary income, except for carried interest on investments held longer than 5 years, which would be deemed 50% ordinary income.  However, the change failed to garner any Republican support. After failing to get the 60 votes necessary to end debate on the measure, Sen. Reid withdrew the bill from consideration on June 25th.

As NVCA’s legislative team noted, the bill’s failure does not mean that a change in the treatment of carried interest has been permanently defeated. Following the passage of the health care legislation in March, Congress has had a difficult time finding provisions to pay for new legislation. Although its future is anything but clear, carried interest seems likely to be introduced as a “pay for” for future programs.