Washington Outlook: With Payroll Tax Holiday Extended, Legislative Action May Subside as Political Messaging Ramps Up In Advance of the Election
After much debate, Congress recently passed the “Middle Class Tax Relief and Job Creation Act of 2012,” and was signed into law by President Obama on February 22. This $143 billion measure maintains the two percentage-point reduction in the payroll tax through the end of the year. The new law also extends jobless benefits for between 63 weeks and 73 weeks, and prevents a sizable cut in the reimbursements doctors receive for treating Medicare patients. During the course of negotiating on the final payroll tax legislation, there were rumors that some Democratic Members would propose using carried interest as one of several tax increase measures to pay for the legislation. At the same time, Republican Members who were involved in brokering the final deal opposed permanently increasing taxes, including carried interest, to pass this temporary measure. Ultimately, Congress passed the law without including tax increases.
With the payroll tax, unemployment insurance and Medicare doctors’ payments issues resolved for the time being, many in Washington believe that the chance of any additional major tax legislation becoming law before the election is low. While this assessment seems accurate for the meantime, there is no question that in advance of the elections in November both parties in both Houses of Congress and all presidential candidates will continue to discuss several tax policy issues, many of which would affect private equity. In addition, irrespective of the outcome of the elections, a series of challenging policy decisions will remain for the President and the Congress during the “lame duck” session this fall. In particular, the scheduled expiration of the 2001 and 2003 tax cuts at the end of the year, a renewal of the legally binding limit on federal borrowing, and the start of a congressionally mandated sequester to automatically cut domestic spending in 2013 will likely force the President and Congress to engage deeply with fiscal issues after the election. Without action in the lame duck session, tax rates will increase for all taxpayers and several important funding decisions will remain unresolved.
With that background, on February 13, President Obama unveiled a $3.8 trillion budget blueprint for FY2013. The budget seeks to raise $1.7 trillion in new revenue over the next ten years. This would come largely from: (1) Allowing the 2001-2003 tax cuts to expire for individuals earning over $200,000 annually (or families earning over $250,000) — resulting in a top ordinary income tax rate of 39.6 percent, a dividends rate of 39.6 percent (up from the current 15 percent), and a capital gains tax rate of 20 percent (up from 15 percent); and (2) Restoring the estate tax to its 2009 level, with a $3.5 million exemption and a top tax rate of 45 percent (there is currently a $5 million exemption and a maximum rate of 35 percent, but this is scheduled to revert to a $1 million exemption and top rate of 55 percent next January absent any further legislative action).
In addition, President Obama once again included a tax increase proposal in his budget that would treat carried interest as ordinary income. The description in the Treasury Department’s related Green Book notes that, “the administration remains committed to working with Congress to develop mechanisms to assure the proper amount of income recharacterization where the business has goodwill or other assets unrelated to the services of the ISPI [Investment Services Partnership Interest] holder.” Nevertheless, neither the administration’s new proposal nor Congressman Levin’s new carried interest bill discussed below would fix the enterprise value problem.
One day after the president released his budget proposal, of the House Ways and Means Committee Ranking Member Sander Levin (D-MI) reintroduced the latest version of his carried interest tax increase legislation (H.R. 4016) that would tax carried interest as ordinary income. Although Congressman Levin has indicated more openness to addressing the enterprise value issue, his bill does not adequately address the problem. Given Republican opposition to increasing taxes on carried interest, we do not anticipate that this bill will become law this year.
Shortly after the President introduced his FY 2013 budget, he released a separate “Framework for Business Tax Reform” document, which addresses in a negative way three issues of importance to private equity and other businesses: (1) interest deductibility; (2) flow-through tax treatment; and (3) carried interest. In laying out a menu of options that the President believes “should be under consideration in reform” in order to lower corporate tax rates to 28 percent, the Framework expressed interest in reducing an alleged bias towards debt financing by, “reducing the deductibility of interest for corporations.” In addition, the Framework outlines that, “Establishing greater parity between large corporations and their large non-corporate counterparts should be considered as a way to help improve equity, reduce distortions in how businesses organize themselves, and finance lower tax rates.” Finally, and not surprisingly, the Framework reiterates that carried interest should be taxed as ordinary income, rather than long-term capital gains. Some pundits have suggested that this document is more a political messaging piece than a detailed policy proposal. Indeed, it discusses high-level business tax reform priorities for the administration, it serves as an important reminder that issues important to the core of the private equity business model will likely be under debate during fundamental tax reform and it remains extremely important for the PE industry to stay actively engaged as these tax reform debates move forward.
