An Associated Press story today on proposed “carried interest” tax hike legislation aimed at soaking private equity had this interesting description of what the proposals would do:
Congress is debating whether to force companies set up as limited partnerships — and their managers — to pay taxes at the same rate as income earned by ordinary Americans.
But reading the fine print of the press release of main sponsor Rep. Sander Levin (D-Mich.) shows that the House bill would also hike the taxes of plenty of “ordinary Americans” as well — specifically, the numerous American shareholders in real estate investment trusts, or REITs.
The question-and-answer section at the end of Levin’s release asks, “Would this affect REITs,” and answers, albeit in a convoluted way, in the affirmative:
To the extent that a Real Estate Investment Trust is receiving income in the form of a carried interest in another real estate partnership, this would affect the character of income received for purposes of determining the character of income distributed to shareholders. [Emphasis added]
You may not have understood all of this, but you can probably infer that Levin’s short answer is: Yes, REIT shareholders will get their taxes hiked, too.
Let me try to explain this. In a partnership — private equity or any kind — the partners are taxed on a business’ earnings at individual tax rates instead of the business itself being taxed at corporate rates. In a limited partnership, the general partner gets an ownership stake in exchange for managing the firm and assuming all the legal liabilities for the other partners. He or she will be taxed at the rates of ordinary income for management fees, and for much of the business’ activities. But the general partner will pay the individual capital gains rate when the other partners receive capital gains for sales of such things as stock and real estate. This is called the carried interest.
What Levin’s bill would do is tax the general partner’s carried interest as ordinary income, more than doubling the rate in some cases from the current top capital gains rate of 15 percent to the top personal income tax rate of 35 percent.
But that would just hit those rich private equity barons, right? Well, there’s a saying that when politicians talk about taxing the rich, watch your wallet! As your accountant would say, this is where it’s get interesting.
You see, often the general partner of a partnership is actually a corporation. And in a real estate partnership, that corporation is often a REIT. And since, according to an analysis by the law firm Morrison & Foster, “real estate partnerships are not excluded from the scope of the bill,” this means that “such income would flow through to the REIT’s shareholder as REIT dividends taxed as ordinary income.”
In other words, if you own a REIT in your portfolio, the person hit with this “rich man’s” tax hike would be you! So if this legislation passes, some congratulations are in order. Without earning any extra money, you’ve just achieved the status of a private equity baron! But only for tax purposes.
But knowing that not many Americans would want to achieve this status, CEI has signed a letter — with our friends from Americans for Prosperity, Americans for Tax Reform, and other groups — which points out the flaws of this tax hike and other punitive measures directed against private equity and financial innovation.
As my description should demonstrate, the tax code is a mess. And private equity has prospered in part, as my friend Phil Kerpen points out in an excellent Wall Street Journal op-ed, because of distortions in the tax code and “clear policy errors” such as the monstrous Sarbanes-Oxley law (see CEI’s new YouTube video on Sarbox’s burdens on a budding tattoo entrepreneur), which is “pushing companies out of public capital markets.” But given the broad reach that changes to partnership taxation would have and the damage that could be done both to private equity and other firms, they should not be pursued except as part of comprehensive tax reform that would lower a federal corporate tax rate that is higher than that of most European countries.
For another good general analysis of the carried interest issue, read this paper by Stuart Butler of the Heritage Foundation