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It looks like the industry can breathe a sigh of relief as the fears about a rise in the rate of taxation of carried interest will not come to fruition.

It’s possible the push could be revived. But for now the industry won’t face what many thought would be a doomsday scenario.

Reid will probably fail again, since his own party’s Sen. Ben Nelson (D-Neb.) has joined the Republican opposition against this tax hike bill. Republicans will probably block any tax hike. Sen. Nelson specifically said he does not want the carried interest repeal on real estate partnerships, which are a big factor in every state, unlike like hedge funds, private equity and venture capital funds concentrated in New York, California, Illinois, Massachusetts and other larger states. (Sen. Nelson is winning back stripes after his infamous Cornhusker-kickback health care deal.)

Repealing carried interest is losing appeal as more and more leaders oppose its consequences, unintended or otherwise. It’s a growth killer in this weak economy and it’s un-American to tax small businesses with ordinary income after their lifetime of hard work to build up their business with risk capital. These entrepreneurs, including investment managers, deserve capital gains when appropriate. And remember, often times carried interest is ordinary income too.

The bill in front of the Senate keeps morphing. I’m not sure what this makes the effective tax rate, but the language does keep changing and is different from what ultimately passed the House. That means any changes will have to be ironed out in conference, which might provide the industry one last chance to alter the carried interest language even further.

Here’s what came out of the committee discussing the bill as was reported at The Hill:

The bill would prevent investment fund managers from paying taxes entirely at capital gains rates on investment management services income received as carried interest in an investment fund. To the extent that carried interest reflects a
return on invested capital, the bill would continue to tax carried interest at capital gain tax rates. However, to the extent that carried interest does not reflect a return on invested capital, this amendment would require investment fund managers to treat seventy-five percent (75%) of the remaining carried interest as ordinary income beginning on January 1, 2011. The amount that will be treated as ordinary income is reduced to fifty percent (50%) for carried interest that does not reflect a return on invested capital but which is attributable to the sale of assets which are held for 5 or more years. This amendment provides that the lower recharacterization percentage also applies to the gain or loss attributable to the underlying assets held for 5 or more years when a partnership interest is sold as well as to gain attributable to section 197 intangibles of a partnership whose principal activity is providing specific investment management services with respect to the assets of the partnership when the partnership interest has been held for 5 or more years. This amendment also provides that, on selling an interest in any publicly traded
partnership, a person who is not an investment service provider will be exempt from the rule that recharacterizes as ordinary income under Internal Revenue Code section 751(a) that portion of the gain or loss attributable to an investment services partnership interest. This proposal, as amended, is estimated to raise $13.905 billion over 10 years.

I’m not sure what that means, but the number quoted at the end is lower than the original revenue estimates of what the raise in carried interest taxes was supposed to achieve.

Here’s Bloomberg Business Week’s summation:

Baucus’s new proposal would create a multitiered tax rate affecting some venture capital fund managers that declines the longer the funds are managed. Fund executives who manage a fund for one to five years would pay ordinary tax rates on 75 percent of their profit share, known as carried interest, and capital gains rates on the other 25 percent. For investments of more than five years, the rate would be a blend of 50 percent ordinary tax rates and 50 percent capital gains.

It also would exempt shareholders of Blackstone Group LP and other publicly traded buyout firms from facing higher taxes if they sell shares at a profit.

And here is how Reuters described the alterations:

The new investment fund managers’s tax, called carried interest, would tax 75 percent of investment fund managers income at ordinary tax rates, with an exception for assets held at least 5 years, of which only 50 percent would be taxed at ordinary income rates, according to committee documents.

The new proposal also eases the tax’s impact on the sale of partnership shares.

The original Senate bill’s carried interest proposal would have taxed 65 percent of investment fund managers’ earnings at higher normal income tax rates. Currently investment fund managers enjoy a lower 15 percent capital gains tax rate on their earnings from managing investors’ money.

The new carried interest language brings the bill more in line with a bill passed by the House of Representatives, which called for 75 percent of earnings to be taxed at higher normal income tax rates.