Carried Interest Tax Hike Deal Close

Jun 8 2010 | 10:52am ET

Democrats in the U.S. Senate are nearing a deal that would more than double the taxes paid by hedge fund and private equity fund managers on their shares of their funds’ profits.

The proposal would, however, be slightly more favorable to the alternative investments industry that one passed by the House of Representatives last month. Under the possible Senate deal, “carried interest” would no longer be taxed at the capital gains rate of 15%, but it would also be taxed less than ordinary income, whose rate is set to increase to 39%.

Performance and incentive fee income would instead by taxed at 32.7%, The Wall Street Journal reports. Venture capitalists would get an even better deal, with their profits on investments held for at least seven years taxed at 30.7%.

The latter is thought to be a concession to Sens. Mark Warner (D-Va.) and Bob Casey (D-Pa.), who have withheld their support for the proposal so far. Both believe that VC, which they say funds innovation, should get a better deal.

Still, passing the measure is by no means assured. Democrats would need the support of at least one Republican to end debate on the bill and send it to a vote, which they do not yet have. Closing the carried interest loophole is part of a broader bill that would extend unemployment benefits and some tax breaks, with debate set to begin today.

Under the tentative Senate proposal, alternative investment managers would pay an additional $14.5 billion in taxes over the next 10 years. That’s a $3 billion break from the House bill.

Meanwhile, one hedge fund billionaire has made a play to skirt the new taxes, should they come into effect. Edward Lampert’s ESL Partners on Wednesday distributed some $829 million in shares held by the hedge fund to him. Under the terms of the distribution, Lampert can only sell the AutoNation, AutoZone and Sears Holdings shares at the same time and under the same terms as ESL.

The move means that Lampert will be taxed at the capital-gains rate when he does, rather than at the new, higher rate for performance fees.

It is the second such distribution from ESL to Lampert this year, with the first $10.3 million distribution coming in January.

It is unclear whether Lampert made the move to shield himself from the potential new tax liability or for estate-planning purposes.

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