Private equity investors were stunned last week when Sens. Joe Manchin and Chuck Schumer agreed to a giant reconciliation bill. Not only that Manchin got to yes on anything, but that he adopted very convoluted language on changing the tax treatment of carried interest.
The big picture: This could become a full employment act for private equity fund accountants.
What to know: We don't yet have full legislative text of Manchin's bill, with Senate Democrats instead only providing a one-page summary. But multiple sources say the carry change would be cribbed from the House version of Build Back Better (RIP).
- This does not recharacterize carried interest as ordinary income, which everyone agrees would be the cleanest way to close the loophole (even among those who bristle at the suggestion that it is a loophole).
- Instead it focuses on holding periods. First by expanding the minimum holding period for capital gains treatment on PE carried interest from three years to five years. Second, by starting the clock on the later of the date on which the fund acquired "substantially all" of its carried interest, or the date on which it acquired "substantially all" of its assets.
- [Update: Senate Democrats have now released legislative language, and the carry provision does indeed mirror BBB.]
Here's the problem, as explained by law firm Gibson Dunn: "The Act does not specify how the 'substantially all' requirement is intended to be measured, and, because 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 satisfied."
- Beyond that, the language also creates perverse incentives for PE investors by creating different minimum hold times for different portfolio companies within the same fund.
- Word is 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 plan.
- "Congress has got to provide more guidance on what it intends fund managers to pay," a private equity attorney tells me. "Otherwise you'll get a free-for-all because no one can really understand this."
Wildcard: It's still very possible that Sinema again refuses to play ball, or that she insists on dropping tax provisions like carry and corporate minimums. Axios' Alayna Treene last night reported more on her thinking.
- The American Investment Council, a PE lobbying group, notes that there are nearly 150 private capital firms based in Arizona, plus 678 PE-backed portfolio companies that employ 229,000 Arizonans.
Savings: Senate Democrats claim that their carry 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.
- Also worth noting that $14 billon is the same figure used by CBO in 2019 for a proposal that would have treated carry as ordinary income. Pretty sure the short-term outlook for PE profits was a bit stronger in 2019 than in 2022...
The bottom line: The political debate over carried interest taxation began more than a decade ago. It's no less messy today than it was back then.
