The good news is a financial-transaction tax (FTT) isn’t part of the new Senate and House bills for financial reform and tax changes, but there is, of course, some bad news: The carried interest repeal is on the table again.

Details of this joint effort between the House of Representatives and Senate were released last week. The “American Jobs and Closing Tax Loopholes Act of 2010” (H.R. 4123) proposes repealing carried interest tax breaks and closing the self-employment (SE) tax loophole for S-corps, alongside other changes of less importance to traders. This is a new version of the bill passed by the House in December, and is now up for a vote in both the House and Senate. As of this writing, nothing has been passed yet, but passage is expected after a fight. 

There are also heated objections from the venture capital and real estate industries, who don’t want to be lumped with hedge fund managers. They argue their case is different on carried interest because they’re more long-term players in less lucrative industries than hedge funds, and this tax will hurt their vital industries. Congressional leaders are considering subjecting only 60 percent of their carried interest income to the ordinary rate, while leaving it at 75 percent for hedge fund managers.

Perhaps Blue Dog Democrats have an eye out to austerity measures being passed around Europe to tackle run away social and entitlement benefits, and they’re considering the upcoming midterm elections and the political danger of more deficit spending on entitlements.

What do these changes mean? 
Currently, investment managers in hedge funds using profit allocation — otherwise known as “carried interest” — instead of an incentive fee enjoy lower 60/40 tax rates on futures (a blended maximum rate of 23 percent), and lower long-term capital gains tax rates on securities. (If held over 12 months, the maximum rate for the latter group is 15 percent.) 

If the repeal passes, carried interest income will be re-characterized for the investment manager as ordinary income. Carried interest is different from incentive fees. The former is considered investment unearned income and the latter is classified as earned income subject to the SE tax. Currently, the SE tax rate is 12.4 percent on the social security base amount ($106,800) and 2.9 percent unlimited thereafter. The unlimited Medicare portion is a great concern of managers with large carried interest income. Also starting in 2013, upper-income taxpayers’ investment income will be subject to the 3.8-percent Medicare tax. Whether treated as carried interest investment income or as re-characterized ordinary earned income, the adviser will owe that 3.8-percent Medicare tax on that income. 

Previous versions of this tax change asked to classify 100 percent of carried interest as ordinary income, but this rendition calls for a 75-percent re-characterization; the remaining 25 percent would retain the underlying income tax treatment for short- or long-term capital gains, 60/40 futures or interest income. 

If this 25 percent “break” survives, it will still make sense to keep carried interest structured into hedge fund vehicles. Managed accounts have management and incentive fees taxed at ordinary rates and subject to SE tax. They don’t fall in the category of carried interest. Hedge funds require more compliance costs than managed accounts. Traditionally, tax benefits have been one of the pros of hedge funds and that edge should remain if this bill is passed as stated. 

Also, unlike previous versions, this bill offers a phase-in period of two years. In 2011 and 2012, half of carried interest would be taxed at the ordinary income rate, with the remaining 50 percent eligible for capital gains treatment. Finally, in 2013 and thereafter, 75 percent of the carried interest would be taxed under the new rules. 

Tax increases all around
This tax increase for investment managers is made even more painful when other scheduled tax increases are factored in. All income tax rates are scheduled to rise in 2011 when the Bush Administration tax cuts expire. Congress and the President want to extend those tax cuts for the middle class only, which excludes the upper income making more than $250,000 per year (filing jointly). The long-term capital gains rate is scheduled to rise from 15 to 20 percent and the ordinary rate shoots up to 39.6 percent from 35 percent — returning to the Clinton Administration tax rates. The blended 60/40 futures tax rate will rise from 23 to 28 percent. The alternative minimum tax (AMT) rate will stay at 28 percent. The qualifying dividends tax rate will rise from 15 to 39.6 percent — back to the ordinary tax rate. The President wants to fix the dividend rate only, using the 20 percent revised capital gains rate. 

An unfair repeal 
Personally, I think this repeal is a mistake and unfair. Managers risk their time, effort, reputation, brand and sweat equity in their funds, which I believe is tantamount to money. All of this risk capital should be subject to capital gains taxes and not ordinary rates. Funds also pay investment managers management fees, which are reported as earned ordinary income. The carried interest portion is managers’ pro-rata share of return on risk capital, putting them in the same boat as their investors. Proponents of this tax are using convenient (and faulty) logic as a means to their end: to raise taxes where the money is — in hedge funds and on Wall Street.

Is there a workaround? 
The only legal way an investment manager can avoid the carried interest re-characterization is to personally invest his own money in his hedge fund. The bill contains “abuse provisions” to protect the Treasury from inappropriate behavior, and specifically says loans can’t be used to make cash investments. The new health care tax law beefed up tax avoidance scheme rules that make this type of behavior very dangerous for a taxpayer.

Closing the S-corp loophole
In the past, investment managers for funds and managed accounts have reduced the SE tax on advisory fee income with an S-corp tax vehicle. The IRS knows S-corps are used in this manner and it insists on reasonable compensation to the owner/manager to pay some SE or payroll taxes. Guidelines suggest that the 30 percent is “reasonable,” which means the owner saves the SE tax on the remaining 70 percent of fee income. 

Before you get too excited at the prospect of using an S-corp to reduce SE tax on the repeal of carried interest, here’s the bad news. The new bill has proposed to repeal the S-corp SE tax loophole. According to Thomson Reuters, “… the bill would address the situation where service professionals have been avoiding Medicare and Social Security taxes by routing their self-employment income through a corporation where (1) an S corporation is engaged in a professional service business that principally based on the reputation and skill of 3 or fewer individuals or (2) an S corporation is a partner in a professional service business.” 

It appears Congress wants to close the SE tax loophole for smaller companies — one-person professionals who use the S-corp to avoid payroll. Many small investment managers have less than three people, but larger ones might not be affected here. Unless, Congress hangs their hat on “principally based on the reputation and skill of 3 or fewer individuals.” Even some of the larger investment managers have their reputation based on a few key managers.

Investment managers affected by this change may as well remain in an LLC structure filing partnership tax returns, which is usually preferred by their attorneys for governance reasons. Partnership returns are also better than S-corp tax returns. The owner/manager can use administration fees rather than payroll which have added compliance costs. Partnerships can use special tax allocations to owners, whereas S-corps may not. 

Better than a FTT
These tax changes will collectively raise the income tax bills of profitable investment managers. It’s unfortunate, but better than a nasty, industry-killing financial-transaction tax. A FTT is the worst-case scenario for traders, so its absence from this legislation is something to be thankful for. But I don’t trust governments in today’s “meltdown” environment. Bank taxes and/or a potential FTT is being coordinated on a G-20 level and it may be absent from this legislation for that reason too. The Administration wants a bank “fee” (i.e., tax) and they have said no to a global FTT. 

Looking on the bright side, these financial regulations and tax changes should bring more market volatility, so hopefully traders can make back some of the extra costs in trading.