The House “extenders package” has a pair of tax increases on investment partnerships (Sec. 411 and 412). Investment partnerships consist of a “general partner” who makes investment decisions for the partnership. It also consists of “limited partners” who contribute money to the partnership. Limited partners are usually large investors like defined-benefit pension plans, university endowments, and charities.
The two tax hikes in question each involve the general partner. A general partner is usually compensated under a system known as “two-and-twenty,” or a similar arrangement. Under this system, the general partner receives a taxable salary equal to two percent of the assets under management (like all salary, this is taxed at ordinary income tax rates). He also earns a twenty percent share of the profit he can generate for the partnership. It’s important to note that this profit share only becomes available after the limited partners have gotten a set return themselves. The general partner can also sell his ownership interest in the partnership, and would pay capital gains tax on any profit from that sale.
The extenders bill raises the tax rate the general partner pays on capital gains (either from the sale of the ownership interest, or the sale of partnership investment assets) from 15 percent today to 38.5 percent in 2013. This is done by requiring three-fourths of the capital gain to be taxed at ordinary income tax rates. Both the capital gain and ordinary tax rates are scheduled to rise in 2011 under the Congressional Democrat and Obama budgets. Additionally, Obamacare imposes an investment surtax of 3.8 percent in 2013. Below is the tax rate on these capital gains for each of the next several years:
What will be the result of this 157% tax hike on general partners of investment firms? One possibility is that the general partner will demand a higher percentage of profits, in order to make himself whole on an after-tax basis. For example, a partner with a 20 percent share of the profits today might need to be able to claim 30 or 40 percent tomorrow in order to get the same after-tax return. This, in turn, would leave less profits available for the limited partners—defined benefit pension plans, university endowments, and charities. This tax hike could easily become a tax hike on them, not general partners.
America’s trading competitors have no such desire to punish savings. India has no capital gains tax, and the rate is a low 10 percent in China. Even in the United Kingdom, the rate is only 18 percent.
The ultimate goal of Congressional Democrats is clear: piece by piece, they want to tax all capital gains at ordinary income tax rates. If that happens, the combined federal-state rate on capital gains could easily approach 50 percent—stifling investment in jobs and growth.