The federal government needs cash, and we all know it has to come from somewhere. As no politician has ever been criticized (at least not broadly) for going after the folks with the deepest pockets, private equity industry needs to dig in for what could become a fierce battle over new taxes. The issue isn't new. For a while now, the feds have been kicking around new taxes on private equity firms based on how profits are classified. Yet, this search for cash could have unintended consequences, as the definitions used could wind up taxing venture capital funds and small partnerships, which could be the keys to an economic recovery. Critics argue that the tax may not bring in as much money as the government hopes.
With unemployment at 9.7% -- an improvement but still very high -- people are still thinking about jobs above all else. The jobs need to come from somewhere, and we seem to have two choices: stimulus plans or private industry. If you lean toward the former, it would make sense to tax the private equity sector. After all, a government job creation packaged would have to be financed by something. But if you're looking to the economy to heal itself – which is more likely – taxing the private equity industry is a colossal mistake.
Private equity funds, which, using prevailing definitions, would include the venture capital and small partnership spaces, have the capital that will be invested in companies to facilitate growth. What follows growth? Jobs. Keeping those assets under management -- rather than in the fed's coffers -- means it's more likely to be put to work, as fund managers need to deploy capital in order to generate returns for their limited partners. Do the math: this is where you'll find the jobs.
So, what's the threat?
Specifically, the government is looking at something called "carried interest." This is the 20% of profits that private equity partners claim as part of the fund's compensation for performance. It's a pay for performance model, in which the big money doesn't materialize in bad years, but which fattens pockets when the fund manager's do their jobs well. To pay out, the fund typically has to clear a performance hurdle of around 8%.
At present, carried interest is taxed at a rate of 15%, but the latest proposal, made by the Obama administration, would pump it up to that of ordinary income, which is 35% for the highest tax bracket.
Steven Kaplan, finance professor at the University of Chicago, told Reuters, "In its favor, it will pick up some taxes," but he believes it will come at a price. "It will hit the private equity and particularly venture capital firms, and in this day and age, they're not the bad guys." Kaplan puts the odds of the tax passing at 50:50.
The administration believes the tax will raise $24 billion over the next decade – funds that could be put to work in the economy to generate wealth and jobs ... not to mention the new ideas that accelerate both.
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