House AMT Fix Would End Capital Gains Treatment of Hedge Fund Managers' Carried Interest

A House bill protecting taxpayers from experiencing a tax increase under the alternative minimum tax would be primarily paid for by ending the capital gains treatment of carried interest earned by hedge fund and other asset managers. The House recently passed H.R. 6275, the Alternative Minimum Tax Relief Act of 2008, by a vote of 233-189.

The alternative minimum tax was originally passed in 1969 and was intended to stop a small number of wealthy individuals from avoiding paying any income tax by taking numerous deductions. However, as the AMT was never indexed for inflation, the tax will hit millions of middle class families this year if corrective legislation is not enacted.

Hedge and private equity funds are typically structured as partnerships for federal tax purposes. Managers of these funds often receive an asset-based management fee of 2 percent of the fund’s committed capital and an interest of 20 percent in the profits of the fund. The 20 percent profits interest is referred to as the carried interest. For managers of private equity funds and hedge funds, the carried interest often represents a substantial portion of their total return from the funds.

Upon receipt of the carried interest, the fund manager becomes a partner in the fund and pays tax in the same manner as other partners on his distributive share of the fund’s taxable income. The character of the income included in the manager’s distributive share is the same as the character of the income recognized by the fund. Thus, if the fund earns ordinary income or short-term or long-term capital gain, each partner’s distributive share includes a portion of that income. For example, if the fund sells stock of a portfolio company that it has held for more than a year, the manager’s share of the long-term capital gain is taxed at the 15-percent federal long-term capital gain rate.

To make the bill revenue neutral, the House offset the AMT fix by providing that carried interest would be taxed as income rather than at the lower capital gains rate. The House believes that carried interest is money earned on a service provided by fund managers, not money earned on their personal investments.

In floor remarks, Rep. Sander Levin, sponsor of the offset provision, assured hedge fund managers that they will still get capital gains treatment on that portion of the profits representing their own money in the funds they manage. In other words, capital gains tax treatment will still be available to the extent that gain is attributable to the manager’s invested capital. But the compensation for services portion of the carried interest would be treated as ordinary income.

Rep. Levin analogized the compensation for asset management services to stock options. Both carried interest and options are performance-related incentive compensation, he reasoned, and both should be taxed at ordinary rates. He noted that the Joint Committee on Taxation's revenue estimate for the carried interest provision indicates that over $150 billion in income will be taxed at capital gains rates rather than ordinary income rates if this change is not made.