By Dina ElBoghdady
Washington Post Staff Writer
Saturday, February 20, 2010; A14

Even as populist anger at Wall Street has reached a crescendo this winter, the Obama administration's drive to eliminate what critics call a lucrative tax break for wealthy financiers has stalled in Congress.

As part of his budget, President Obama offered a proposal last month to significantly increase the levy paid by managers of private-equity firms and other investment partnerships. And Treasury Secretary Timothy F. Geithner told a Senate panel this month that the administration is committed to this tax policy change, which could more than double the tax rate on income known as "carried interest" or "carry."

Yet, the initiative has lost momentum in the Senate, much as it did nearly three years earlier when this tax break first riveted the attention of lawmakers because of the sudden and astounding rise in wealth of hedge funds and private-equity firms. Summing up the widespread outrage over this tax break, billionaire investor Warren E. Buffett said at the time that it was wrong for him to pay taxes at a lower rate than did his $60,000-a-year secretary.

The controversy over carried interest soon faded amid the global financial crisis, which battered the profitability of many investment firms. Over recent months, however, the prospects for a change in the tax code had improved as much of the public turned against Wall Street.

The House passed a bill in December that would treat the profits received by partners at private-equity companies and some other firms as ordinary income and tax it at rates as high as 35 percent. Now this income is taxed at the much lower capital-gains rate of 15 percent. The House proposal, introduced by Rep. Sander M. Levin (D-Mich.), would affect partners at private-equity firms, hedge funds, venture-capital firms and real estate investment partnerships.

At issue is how to classify the profits partners receive when their firms sell a long-held asset -- anything from a piece of real estate to a stake in a small start-up to a portfolio of securities. These partners often receive 20 percent of the total profit of the fund.

Testifying three years ago about how much some financiers make from carried interest, Peter Orszag -- who was head of the Congressional Budget Office at the time and is now Obama's budget director -- offered an example: If a fund with $1 billion in assets made a 15 percent profit in a year, a partner could pocket $30 million.

In theory, the capital-gains tax is set at a lower rate than the regular income-tax rate in an effort to encourage people to invest. If an investment makes money, that gain is taxed at a lower rate than if it were a regular salary or interest.

Many economists argue that the partners in these firms should not be treated as investors for tax purposes if they put little or none of their own money into the assets they buy. So the gains should be taxed as ordinary income since partners are essentially providing a service by managing money raised from others, according to critics of the carried interest tax break.

But the Senate has not taken up the issue. Senate Majority Leader Harry M. Reid (D-Nev.) opted last week not to include the carried interest language in a jobs creation bill expected to reach the Senate floor next week. Earlier, there had been discussion among lawmakers about whether to include this tax provision to help offset costs of other spending in a previous version of the legislation.

Senate Finance Committee Chairman Max Baucus (D-Mont.) prefers to deal with the issue in a broader tax-reform measure, his spokesman said.

"There is very little appetite for this tax in the Senate right now," said Scott Talbott, senior vice president of government affairs at the Financial Services Roundtable. "It's rarely a good idea to raise taxes, but especially not during these tough economic times."

Lobbyists who track the issue say the proposal is now dormant. But even those who oppose the tax hike say it is ultimately bound to pass as Congress comes under more pressure to reduce the deficit and raise revenues.

At a Senate hearing this month, Sen. Sheldon Whitehouse (D-R.I.) described the favorable tax treatment as a loophole that allows the nation's wealthiest individuals to get away with paying less than their fair share of taxes.

"To me that is just something that is very, very wrong with America," he said.

But groups lobbying to retain the tax break say it is legally sound and getting rid of it would undermine the entrepreneurial spirit.

"For decades, Americans have formed investment partnerships that give ownership stakes to those who contribute capital and those who contribute their vision and expertise," said Douglas Lowenstein, president of the Private Equity Council. "Private-equity partners contribute both. If the result is making a business more valuable, they are entitled to a capital gain."

The most vocal opposition to the tax increase comes from real estate investment partnerships, which make up nearly half of the nation's 3 million investment partnerships. NAIOP, an association that represents commercial real estate developers, urged its 16,500 members to lobby against the initiative.

The Institute of Real Estate Management, an association of 18,000 property managers, launched its own lobbying effort alongside the National Association of Realtors and one of its commercial real estate affiliates.

The real estate industry, because of its size and presence in almost every congressional district, wields considerable political clout.

These groups say that say raising the taxes that partners pay would discourage investment in real estate at a time when the economy needs it most.

"One of the incentives of investing in real estate is the capital-gains treatment," said Chuck Achilles, vice president of legislation and research at IREM. "Without that incentive, the partners who put these real estate deals together may move on to areas of investment that can provide better returns for them or better tax advantages."