Democrats complicate private equity tax loophole

Private equity investors were stunned last week when the senses. Joe Manchin and Chuck Schumer agreed to a giant reconciliation bill. Not only did Manchin get yes on anything, but he took some very convoluted language about changing the tax treatment of deferred interest.

The big picture: It could become a full employment law for private equity fund accountants.

What there is to know: We don’t yet have the full legislative text of Manchin’s bill, with Senate Democrats providing only a one-page summary instead. But multiple sources claim the port change would be modeled after the House version of Build Back Better (RIP).

  • This does not reclassifying the interest earned as ordinary income, which everyone agrees would be the cleanest way to close the loophole (even among those who bristle at the idea that it’s a loophole ).
  • Instead, it focuses on holding periods. First, by expanding the minimum holding period for capital gains treatment on private equity interest from three to five years. Second, by starting the clock on the date the fund acquired “substantially all” of its deferred holdings or the date it acquired “substantially all” of its assets, whichever is later.

here is the problemas the law firm Gibson Dunn explains: “The law does not specify how the ‘substantially all’ requirement is meant to be measured, and, as many investment funds (e.g., hedge funds and private equity funds) acquire assets at different times and have overlapping holding periods, it would be extraordinarily difficult for taxpayers to determine when these requirements have been met.”

  • Beyond that, the language also creates perverse incentives for private equity investors by creating different minimum holding times for different portfolio companies within the same fund.
  • Rumor has it that House Democrats were working to fix the BBB language until Manchin and Sen. Kyrsten Sinema torpedoed the entire package. But nothing was ever codified, which is why the new plan is the same as the old one.
  • “Congress needs to provide more guidance on what it intends to pay fund managers,” a private equity lawyer tells me. “Otherwise you’ll have an every man for himself because no one can really figure that out.”

Wildcard: It’s still very possible that Sinema will refuse to play ball again, or that she will insist on scrapping tax provisions such as carry and social minimums. Alayna Treene from Axios last night reported more on his thinking.

  • The American Investment Council, an EP lobby group, notes that there are nearly 150 private equity firms based in Arizona, as well as 678 EP-backed holding companies that employ 229,000 Arizonans.

Savings: Senate Democrats say their tax changes could generate $14 billion over 10 years. Pretty impressive. Not the number per se, but that anyone felt comfortable calculating a number given the legislative vagueness.

  • It’s also worth noting that $14 billion is the same figure used by CBO in 2019 for a proposal that would have treated carry as ordinary income. I’m pretty sure the near-term outlook for private equity earnings was a bit stronger in 2019 than in 2022…

The bottom line: The political debate on the taxation of carried interest began more than ten years ago. It’s no less messy today than it was then.

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