For more than 40 years the question of whether "carried interest" of general partners of limited partnerships should be treated as capital gains or ordinary income for tax purposes has been a ticking time bomb waiting to be elevated to a higher level of public dialogue. During this time it has consistently been treated as capital gain under the tax code.
Carried interest is now the subject of active public debate brought about purely as a result of Congress seeking wherever it can, to deal with the need for new sources of revenue. In a matter of days it will likely be resolved to treat carried interest as ordinary income thus increasing the tax burden on thousands of general partners of limited partnership vehicles which invest in everything from energy to real estate to private equity and my own area of interest, venture capital. While I will be a casualty of the new legislation and while I believe strongly that if we, as a nation wish to encourage start-up formation and entrepreneurship, that there should be a carve out for partnerships focused on small early stage investments, I must admit that in its essential character, carried interest can be construed as ordinary income as it does not meet the test of an interest "at risk" necessary to be treated as a capital gain. In spite of that fact, I can argue that the middle of a recession is not a propitious time to increase the tax burden of the specific segment of the economy, namely venture capital, which is a gross and net creator of jobs. Nevertheless, reluctantly I will accept the outcome.
On the other hand, in the further quest to raise tax revenue it is now proposed additionally to create an "Enterprise Value Tax" (EVT) at ordinary tax rates upon the sale of the entities which manage these partnerships. In so doing, Congress is compounding the burden and is proposing to go far beyond any rational tax policy in what can only be described as a confiscatory manner. The proposed EVT would have far reaching negative implication for over 10 million individuals who have used the investment partnerships to run their business.
The Enterprise Value Tax is unprecedented, punitive and has no justification in the tax code. It will create the first class of American business that will not be afforded capital gains treatment upon sale or transfer and will affect millions of well-meaning people. These individuals have built farms, buildings as well as established a myriad of small companies in industries that are the job creation engine of our economic system. They have the rightful expectation that upon the sale of their business - many of which have been built over decades - they will be afforded capital gains treatment as does every other business.
Some tax experts are claiming that the enterprise tax is necessary to prevent circumvention of the new tax on carried interest. But that not only assumes that the seller of an investment partnership would be willing to commit fraud (guilty until proven innocent is not a part of the American tradition) but ignores both tools in the existing tax code and far less sweeping measures that would ensure that the new tax is properly collected.
The other justification advanced for the enterprise tax is the seductively large amount of revenue it would ostensibly collect. In times of huge fiscal deficits, no new revenues can be ignored and renouncing any becomes well nigh politically impossible. But most outside experts who have examined the new tax on carried interest say that the Congress has both woefully underestimated the amount the new tax on carry would raise and drastically overestimated the amount the enterprise tax would raise as investors and entrepreneurs alter their behavior to avoid it.
Congress can meet its revenue goals without this new tax, and investors are needed more than ever to sink capital into our economy and stay with it over the long term. Now is not the time to turn them away.
Great care should be taken before Congress implements legislation which vividly illustrates the law of unintended consequences.