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Tax break favors the high-fliers

With no code change, fund managers still pay much lower rate

By Donovan Slack
Globe Staff / December 29, 2010

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WASHINGTON — Hedge fund managers, venture capitalists, and other financial high-fliers have more to celebrate this holiday season than year-end bonus checks.

Thanks to a $4 million lobbying campaign in Congress, and the support of key senators in both parties, these financial managers are still paying much less in taxes on income they get from successful investments, because of a special federal tax break. While wage earners are taxed as high as 35 percent, the investment managers pay the lower capital gains rate of 15 percent on this income.

Venture capitalists and similar investment managers argue the tax break is an essential economic tool because it provides them with an incentive to make successful investments that create jobs. Massachusetts has some of the nation’s most prominent venture capital and private equity firms, and a sizable community of hedge funds, so its members have been prime beneficiaries of the special tax break.

Meanwhile critics, including President Obama, contend the break is an example of the inequity of tax rates. Obama targeted it for elimination, so the fund managers would be taxed at the same rate as wage earners. The administration said the change would yield $24 billion in taxes over the next 10 years.

But despite the House of Representatives soundly supporting elimination of the tax break, the effort got no further as the Senate declined to go along this year.

The Real Estate Roundtable, which represents commercial real estate developers and investors, said its members would be hurt by the elimination of the tax break because it benefits real estate partnerships. The group said it took a “significant educational effort’’ to persuade lawmakers to keep the tax structure in place.

“This proposal would have been a job killer and would have been counter-productive to putting the economy back on the right trajectory,’’ the Roundtable’s president, Jeffrey DeBoer, said in an interview.

Since the legislation never even came up for a final vote in the Senate, proponents of ending the tax break were deprived of the kind of make-or-break marquee showing that could have focused more attention on it.

Representative Richard Neal, the Springfield Democrat, said his party could have done a better job highlighting the issue. He said the effort to eliminate the break failed because Democrats were divided about whether to eliminate the tax break for some types of fund managers. Lobbyists then exploited that division.

And now, with Republicans taking over the House and gaining more seats in the Senate, the tax break issue is likely to recede further — unless it becomes part of a larger overhaul of the US tax system that both parties have suggested they want to tackle next year.

At issue is the money that managers of investment partnerships such as venture capital, private equity, and hedge funds receive when their investment bets pay off. Often these managers collect a percentage of the fund profits, which is known as carried interest. And since that fee typically is 20 percent of the gain in a multibillion dollar fund, the payday for the more successful managers can easily run into the millions of dollars. It’s this pay which is taxed at the special rate of 15 percent.

The tax break is largely limited to managers of funds organized as investment partnerships. It isn’t extended to managers of other kinds of investment vehicles, such as mutual funds.

Critics contend the carried interest payday is basically a bonus, no different than what a mutual fund manager, commercial salesperson, or corporate executive would get for doing a job well, and therefore does not deserve special treatment.

“Everyone else who’s performing a service, they don’t get a special tax rate,’’ said Nicole Tichon, a specialist at US PIRG, a Washington, D.C.-based association of consumer groups. Tichon said the tax break is an enormous windfall to some of the nation’s wealthiest people — top fund managers bring home anywhere from $75 million to $570 million — and yet their tax rate on those payoffs is the same as for workers at the low-end of the pay scale, earning $8,000 and $34,000 per year.

“It’s unfathomable that by simply mislabeling their income these mega-millionaires are taxed at a rate less than teachers, police officers, and small business owners, for example,’’ Tichon said.

But lobbyists for the industry said eliminating the tax break would be unfair.

“Our position was that unfairly singling out private equity, venture capital, and real estate partnerships for a 157 percent increase in taxes on the capital gains they earn would discourage investment,’’ said Doug Lowenstein, president of the Private Equity Council, which represents corporate buyout funds.

One reason the tax break survived is that some senators sought to exempt sectors of the industry they represent back home, such as Senator Scott Brown, a Republican from Massachusetts who wanted to protect the venture capital industry in Greater Boston.

Brown wrote to the Senate Finance Committee leaders in May, asking to have the tax break preserved for venture capital fund managers who “contribute to the viability of our start-up community.’’ Four Democrats joined Brown in signing the letter, including Senator Jeanne Shaheen of New Hampshire.

Brown’s office did not respond to messages seeking comment.

Meanwhile, Democrat John F. Kerry separately said he didn’t support eliminating the tax break outright, but rather wanted a compromise “that avoided any unintended consequences for Massachusetts.’’

“Unfortunately, near lockstep Republican obstruction guaranteed that this reform couldn’t be passed into law,’’ Kerry spokeswoman Jodi Seth said yesterday.

In May, Kerry argued the tax should differentiate between responsible, long-term investors from those who invest for quick profits.

Industry groups in Massachusetts say preserving the tax break will help the Massachusetts economy, which boasted $2 billion in venture capital investment.

“From a venture perspective, maintaining the current standard of carried interest will continue to encourage venture investing in Massachusetts,’’ said Nancy Saucier, executive director of the New England Venture Capital Association.

Donovan Slack can be reached at dslack@globe.com. Follow her on Twitter @DonovanSlack.