If Congress is allowed to penalize private equity with stifling tax hikes, however, it will undermine American competitiveness... Congress Presses Private Equity Tax Hikes:  Why You Should Care

Tax Increase Would Punish Everyday Americans, Penalize Entrepreneurship and Drive Capital Overseas 

Congress, including some who are usually more reliable anti-tax members, now seeks to raise taxes on private equity partnerships, partnership performance fees and venture capital.  But why should everyday Americans care? 

After all, this particular tax would only target corporate fat cats who are gaming the tax code through high-priced accountants to avoid their fair share of taxes, right? 

Wrong.  This legislation would force even more firms and high-paying jobs from the United States to such overseas market competitors as London, Hong Kong and the Caribbean.  Further, it would constitute an enormous tax increase against everyday investors, their pension funds, retirement savings and the entire American economy. 

"Private equity" generally refers to investments that aren't traded on a public stock market, but rather raised and traded in private markets.  Many private equity firms operate as partnerships, under which a person who contributes an idea or sweat equity in running the operation is given a future profit share, and other partners passively contribute the necessary capital. 

In other words, the partners agree to contribute services to the partnership in exchange for a percentage of future profits.  The ultimate success of the venture is therefore largely dependent upon the value of the vision and labor of the contributing partner. 

To illustrate, imagine that capital Partners A and B agree to contribute $1 million apiece to a venture idea.  Further imagine that Partner C, a computer programmer, creates a venture idea and agrees to provide services in exchange for no up-front compensation but 20% of future profits, if any. 

Under current law, any resulting private equity performance profits are taxed at the 15% capital gains rate, instead of the 35% corporate income tax rate.  This stands to reason, because these profits are not "income."  Rather, they are ownership interests subject to taxation only if the partnership ultimately turns a profit.  Thus, the amount of future profits, if any, is uncertain.  The likelihood of success is not assured.  If the partnership turns no profit, the partner's ultimate compensation will therefore be zero. 

The alternative form of compensation, of course, is to simply pay the contributing partner a salary or set fee.  If the partnership elects to pay in this fashion, that compensation would be taxed at the ordinary income tax rate, because it would be straight compensation without the risk of receiving nothing for one's services. 

So why do partnerships often pay contributing partners in the form of carried interest instead of as straight salary?  Because the uncertainty of the venture means that the value of the services rendered is uncertain as well.  If the venture ultimately profits, then the contributing partner obviously provided a worthy idea and effort, and consequently deserves a proportionately higher reward.  In contrast, if the venture falls flat, the contributing partner presumably deserves less reward for an idea or effort that failed. 

Simply put, this system of carried interest binds the partner's ultimate compensation to the value that he or she provides to the capital investors, and the degree of success of the project.  This tax preference encourages creation of, and investment in, risky but productive entrepreneurship.  It is thus utterly illogical to reclassify this investment as normal income. 

Simple enough, and obviously fair, right? 

Not according to some Senators on constant lookout for additional sources of tax revenue to wring from productive Americans. 

A bill introduced by Senators Max Baucus (D - Montana) and Charles Grassley (R - Iowa) would raise the tax rate upon private partnerships that go public.  And now, Congressman Sander Levin (D - Michigan) has sponsored even broader legislation that would raise taxes on all partnership performance fees by some 133%.    

Senator Max Baucus (D - Montana) openly admitted the cynical nature of his bill, saying, "because it's in the news so much.  There's an awful lot of money there."  In contrast, Alan Greenspan has repeatedly advocated for a capital gains tax of zero.  So whom do you trust more on this issue - Alan Greenspan or tax-hungry Congress? 

This broader tax hike will merely drive investment partnerships out of the United States, and lower the returns for literally millions of Americans whose pensions are invested in private equity. 

Private equity has added tens of billions of dollars for everyday Americans' pension funds, including those of firefighters, police officers, teachers, senior retirees and others.  Additionally, these dollars have relieved the government and American taxpayers from having to bail these pension funds out, as is all-too-common with other failing pension funds. 

The current system thus creates the proper result.  Entrepreneurs are rewarded based upon the risk that they take, and the resulting contribution that they make to the broader economy. 

If Congress is allowed to penalize private equity with stifling tax hikes, however, it will undermine American competitiveness, dampen risk-taking, send firms and high-paying jobs overseas and weaken pension funds for millions of Americans.  At a time when America needs to remain internationally competitive and invest more in innovation, these bills would have precisely the opposite effect. 

Americans who care about their retirement, their investments and the health of the American economy generally must therefore contact their representatives and stop this cynical attempt to punish productivity and further bloat federal coffers. 

July 5 , 2007
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