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DEVELOPERS WARY OF ‘CARRIED INTEREST’ MEASURE

By Dees Stribling

In June Rep. Sander Levin, of Michigan, second-ranking member of the House Ways and Means Committee, introduced a bill that would change the way limited partnerships are taxed. The measure would affect not just hedge and private equity funds, but also limited partnerships and limited liability companies — pervasive structures in the real estate industry, and not least in the retail sector.

In a nutshell, HR 2834 would end the classification of “carried interest” as capital gains, which are taxed at 15 percent. Instead carried interest would be treated as ordinary income, which can be taxed at a maximum rate of 35 percent. Carried interest — sometimes called simply “carry” — is the share of profits the general partners of a fund or a limited or limited liability partnership receive as compensation, despite not contributing any initial funds. Typically, general partners also take management fees, but that is already classified as ordinary income.

If carried interest is taxed as ordinary income, general partners will owe billions more in federal taxes annually. Supporters of the measure — in Congress, on New York Times editorial page and elsewhere — characterize it as a move for tax fairness, pointing out that in the largest equity and hedge funds, general partners are actually risking very little of their own capital while reaping multimillion-dollar payouts at bargain tax rates.

The “piece of equity” the bill targets for higher taxation is a traditional part of compensation at real estate development and management companies (which are often partnerships) and for individuals in private real estate deals, observers say.

When Levin introduced his bill, he went to considerable lengths to stress how it was the fair thing to do. “Fairness requires that [fund managers] be taxed at the rates applicable to service income just as any other American worker,” he said in a press release. Levin’s office did not respond to requests for comment from this publication.

But critics point to the likelihood of unintended consequences. Most limited partnership managers, they argue, are not fat-cat private equity and hedge funds with billion-dollar returns. Rather, they are more modest partnerships in which the general partners really do have a lot at stake, in the form of capital investment, sweat equity and their own reputations. The lower tax rate is meant to provide incentive to such managers, and it works, says Adam W. Ifshin, president and CEO of Tarrytown, N.Y.-based DLC Management Corp.

“People who take entrepreneurial risks will be less willing to do so, because the government will have gotten into their pockets and taken a huge chunk of their profits away,” said Ifshin. “One of the unintended consequences of a bill like this would be to dampen the motivation of real estate risk takers to undertake new deals, which would in turn put a drag on one of the few robust job-creating sectors in the economy.”

Ifshin, along with leaders from the hedge fund and private sectors, testified before Congress last month the tax change would prove particularly detrimental to redevelopment of inner cities and poorer neighborhoods. “Real estate development involves substantial risks and the reward on the back end is what makes that risk worth taking,” he said. “Many of our projects are not short-term in nature.”

And it would be ironic if the biggest fund managers were to remain unaffected, he says. “The really big guys in private equity and hedge funds can afford $1,000-an-hour lawyers to figure out a way around whatever Congress does,” he said. “Also, many of these funds are offshore, and the law would probably drive more of them offshore.”

Fairness is not really the issue, says Charlie Temkin, a director at Deloitte Tax, because the U.S. tax code is so convoluted that judging fairness is tricky business anyway. “There are always going to be disparities in the system,” Temkin said. “This measure is about revenue generation, and if it’s believed that most of the increase is going to be paid by very wealthy people, it will be extremely attractive to Congress. But the impact will be broad. It won’t just be limited to the Blackstones of the world.”