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Wall Street's Lucrative Tax Break Is Under Fire

Levin and some other lawmakers disagree, however, saying there is good reason to treat those earnings as regular income, regardless of decisions by the IRS and its overseer, the Treasury Department.

"The Treasury Department has looked at this as part of its regulatory responsibilities," Levin said. "But that shouldn't constrain Congress from acting to make the tax code more effective and equitable."

Private-equity firms are a relatively recent innovation on Wall Street, having come to prominence over the past two decades. Unregulated by the Securities and Exchange Commission, they amass huge amounts of money from wealthy individuals, pension funds and financial institutions, and use it to buy companies, such as Chrysler and the Hilton hotel chain, two recently announced deals.

Hedge funds are similar in that they pool money from large investors, but they often trade in stocks and bonds that provide financing for corporations.

The highly skilled, hyper-aggressive people who run private-equity firms and hedge funds put some of their own money into the pot, but nowhere near the sums contributed by the other partners, whose profits are taken as capital gains -- that is, returns on their investment of capital.

Instead of money, the managers contribute primarily their expertise to the venture. They raise the money, select the buyout targets and work to make the companies profitable. For that, they are typically rewarded with a 2 percent annual management fee and a 20 percent share of profits when the firm's portfolio of companies is sold, an arrangement known as "2 and 20." The 20 percent profit share is called the carried interest, and private-equity managers treat it as a capital gain.

The debate raging on Capitol Hill revolves around whether managers should continue to claim the payout as a capital gain as the other partners do, or whether they should characterize it instead as compensation for labor.

If the payout is just another partnership share, then the lower capital gains rate would apply. But if the payment is for services rendered, then the higher, ordinary-income tax rates would apply, as they do for the management fee.

No one disputes that the Carry and its tax rate are supported by long legal precedent. The IRS accepts it not only for private-equity managers but also for managers of other kinds of partnerships that deal in capital assets, such as securities, commodities and real estate. Profits from the sale of those assets are almost always taxed as capital gains, a benefit designed to encourage risk-taking by money managers.

But the law makes no distinction between investment partners who contribute money and managing partners who contribute labor. For decades, a debate has raged among tax lawyers and academics over when and how to tax partners who are awarded shares of the profits primarily in exchange for their services.

The matter was first directly raised by the case of Sol Diamond, an Illinois mortgage broker enlisted to secure financing for a building in 1962. A partner provided cash, Diamond delivered a bank loan, and the pair agreed to split the eventual profits. Three weeks later, Diamond sold his interest in the deal for $40,000, which he and his wife, Muriel, claimed as a short-term capital gain.

The IRS objected, arguing that Diamond was made a partner in the deal as payment for his services and that the value of his right to share in the profit should be taxed as ordinary income. In 1971, the courts sided with the IRS in a ruling that launched a long period of hand-wringing but was widely ignored.

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