Democrats’ deferred interest plan seen as tougher than it first appeared

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The House Democrats’ plan to limit a preferred private equity tax break – but not eliminate it altogether as President Joe Biden had proposed – is more restrictive than it first appeared. departure, according to investment advisers and lawyers who reviewed the details of the proposal.

The proposal, which is part of a $ 3.5 trillion package of taxes and expenses that House leaders say could get a vote by Oct. 1, extends the period during which investment funds must hold assets for five years, instead of three years, in order to qualify for so-called deferred interest tax relief.

While that seemed sweeter than Biden’s pitch to kill the advantage – endorsed by Senate Finance Committee Chairman Ron Wyden, D-Ore. – House Democrats had always written the same income estimate. One of the reasons why: Their proposal includes a host of other changes, including new settings on the start of the five-year holding period, restrictions on partners entering and leaving funds, and limits on the long-standing tax relief on the transfer of stakes in the partnership.

The changes could mean that some investment funds must hold much longer than five years to benefit from the lower tax rates, depending on how the Treasury Department implements the change, if it is enacted.

“What appears to be five years could actually be eight years,” said Eric Sloan, partner at Gibson, Dunn & Crutcher law firm, which advises private equity firms. “It’s a big deal.”

The investment hold period clock does not start until a fund has invested “substantially all” of its committed capital – a period that can be anywhere from two to four years for many funds. of private equity.

Not holding investments long enough to qualify for preferential rates under deferred interest can mean much higher tax rates. Under current law, fund managers can pay 20% long-term capital appreciation rates on their products if they meet all of the tax code’s deferred interest requirements, as opposed to the tax rate. income tax; the highest marginal rate is currently 37%.

The House bill proposed to increase the capital gains rate to 25% and the top income rate to 39.6% – leaving the incentive in place to qualify for the lower rate.

While critics of the tax break want it to be eliminated in part as a measure of fairness, supporters say it encourages long-term investment.

“This new bill includes specific provisions that will discourage investment, threaten jobs and weaken pensions for retirees,” Drew Maloney, who heads the private equity trade group American Investment Council, said in a statement. “Instead of pushing a 98% tax hike on private investment, Washington should be pushing more private capital onto main streets across America.”

Bryan Corbett, who heads the Managed Funds Association, which represents hedge funds, says tax preferences for long-term investments are needed to help with the post-pandemic recovery.

“An unintended consequence of this proposal is that partnerships would be treated differently from any other business in the economy, punishing entrepreneurs when selling their business, built over decades, by not letting them benefit from capital gains. long-term. treatment, ”he said in a statement.

Not all tax advisers are worried. Jerry Musi, who advises private equity firms in his role with accounting firm RSM US, says House’s proposal is a “slap on the wrist.” He said he advises clients to hold their investments longer and looks for ways to donate interest to less taxed people.

Yet investment holding periods have become shorter than longer over time, according to Alex Anderson, a partner at O’Melveny & Myers law firm. He said he sees a lot more private equity sales after holding portfolio companies for around 3.5 to four years. That’s down from the roughly six years that had been considered the rule of thumb for average wait times, he said.

What Congress means by “substantially all” of the assets that need to be invested could also have a significant effect on how quickly investment funds could benefit from lower tax breaks. The term “essentially all” appears several times in the tax code, but it is defined in regulations to mean between 30% and 90%, depending on the specific area of ​​the tax code, said Marc Schultz, partner at Snell & Wilmer . .

The House could vote as early as next week on the legislation, which is then expected to be passed by the Senate. Restricting the deferred interest provision is politically important to many Democrats, even though it is only expected to raise $ 14 billion under a $ 3.5 trillion bill.

On the Senate side, Mr Wyden favored the outright elimination of deferred interest, as well as restrictions on other tax preferences for fund managers. Democrats aim to push a final bill through Congress this fall, with weeks or months of negotiations ahead.

“We responsibly fund these policies by simply asking those who are doing extremely well to pay a little more, so that all members of the American family can live in dignity and stability,” said Richard Neal, Chairman of the House Ways and Means Committee. Mass., Said in a statement last week.

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