Private equity and venture capital professionals in the US are a step closer to being taxed at a much higher rate on their income, and their carried interest gains.

July 8, 2021

On May 28, 2021, the Biden administration released its fiscal year 2022 budget proposals, which include two major legislative plans previously released by the administration, the American Jobs Plan (focused on corporate tax reform) and the American Families Plan (focused on individual tax reform). On the same day, the Treasury Department released its highly anticipated “Green Book,” which provides additional detail around the administration’s tax proposals.

The tax proposals in the two plans would have far-reaching effects on private equity sponsors, their principals and their portfolio companies.

It should be stressed that the Biden administration’s budget is only the first step in the legislative process, and it is quite likely that there will be changes made to these proposals as the process plays out on in the coming months.

The Biden administration describes its American Families Plan as “an investment in our children and our families — helping families cover the basic expenses that so many struggle with now, lowering health insurance premiums, and continuing the American Rescue Plan’s historic reductions in child poverty.” To help pay for the plan, the administration proposes what it characterises as “tax reform that rewards work — not wealth.”

The plan calls for significant tax increases on higher-income individuals that would not only reverse certain tax cuts enacted as part of the 2017 tax act, but would also tax certain capital gains and dividend income as ordinary income, a fundamental change to the tax system.

Dubbed the Carried Interest Fairness Act, the legislation would raise the carried interest tax for individuals to 39.6%, the top proposed federal income tax rate. Current tax laws treat carried interest profits as long-term capital gains, which can be as low as 20%. To put that in perspective, a single filer making about $41,000 annually pays 22% in federal income tax.

When Biden first introduced his new tax plan, it was unclear whether he could garner support from Republicans and Democrats, many of whom have deep ties to venture capital and private equity. Doing away with carried interest tax treatment has been floated for years but never received enough support in Congress to pass. Former President Donald Trump campaigned to end the loophole before ultimately agreeing to leave it out of tax cuts passed in 2017.

But circumstances have changed with Democrats in control of the presidency and Congress. However, there is one piece of good news for general partners: Biden has signalled a willingness to negotiate on tax rates, leaving hope that a compromise might be reached.

One US expert commentated: “I expect it might be likely that you find some sort of middle ground there, you know, maybe you’re talking about 25%, 28% raise, something like that, as opposed to going all the way to 39.6%”.

Interestingly, some venture capitalists have signalled support for the principle of a tax hike for partners in the industry. Khosla Ventures founder Vinod Khosla said last month that “sharing the benefits of capitalism is not terrible.”

Biden has also proposed raising the corporate tax rate to 28% from the current 21%, and the top income tax rate to 39.6% for individuals earning more than $400,000 annually. That would also clearly cut into the earned income of fund managers, adding to the extra tax that they would suffer on their carried interest returns.

The National Venture Capital Association and the American Investment Council, the lobbying groups for the VC and PE industries, have denounced the proposed hikes. But that is unlikely to make much impression on the regulators who believe that partners in this industry should easily be able to sustain the higher tax burden, in part because the industry is thriving, more and more funds are coming into the alternatives’ space, returns are impressive and probably they’ve never had more money coming in to their bank accounts.

Nonetheless, as noted above there is still some way to go yet and it is hoped that some sort of middle ground may be found.  Indeed, it is possible that the US could move to a system similar to the one in the UK, where carried interest gains are taxed at 28%, some way above the rate for ordinary capital gains in the UK, but still considerably lower than income tax rates.

Such an outcome would also be welcome in the UK as it would be less likely to cause a rethink over here about whether carried interest gains should be taxed at ordinary income rates.

Here’s hoping!

For further information contact Nigel Mills.

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