Potential Tax Changes Could Slam Financial LPs

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Carlyle Group LP (NASDAQ: CG) co-founder David Rubenstein recently noted during the company's quarterly conference call that he believes the elimination of the carried interest tax "loophole" will be on the table in a second Obama term. This isn't surprising, since it's been on the table before, even while Republicans controlled the White House. This could be a very bad thing for some limited partnerships (LPs). Investors in LPs need to keep an eye on this issue, particularly if they own financially-focused LPs.

What's Carried Interest?
Roughly defined, carried interest is the share of profits that a hedge fund manager or private equity manager get as compensation for his or her services. These fees can be quite large, since 20% of profits is a generally accepted figure (it's the 20 in the "2 and 20" fee structure). Typically, carried interest is treated as a capital gain, allowing this source of income to receive favorable tax treatment. Although this situation has been discussed before, it took center stage during the 2012 presidential election because, according to most accounts, Mitt Romney's wealth is largely attributable to carried interest.

The impact of any tax changes to carried interest could materially alter the cost structure of hedge funds and at private equity shops. While these are areas in which the average investor generally doesn't participate, a small collection of publicly traded private equity firms make it a kitchen table issue. Many of these are set up as limited partnerships.

Such tax changes could reach further down into the LP space, too, impacting energy-related partnerships and some of the "odd" partnerships, like Cedar Fair, which owns amusement parks. However, there is broad support for energy-related partnerships that the financial-related firms just don't have. Moreover, it has been suggested in Washington that the LP structure should, in fact, be extended to allow for solar power and other renewable energy source LPs. So energy-related LPs seem to have much more support.

Some Names To Watch...
Carlyle is one company that investors should be concerned about, particularly since its co-founder has stated as much. However, there are several others that face potential problems, too. This includes Blackstone Group (NYSE: BX) and AllianceBernstein (NYSE: AB), as well non-LP firms like Fortress Investment Group (NYSE: FIG). Anyone already watching this space will note that Alliance is less private equity and more asset manager, which is true. However, simply being in the financial arena and an LP will likely doom the company to being thrown out with the bathwater, and the baby, when the market reacts.

Note, too, the recent conversion of real estate-focused W.P. Carry (NYSE: WPC) from an LP to a REIT via a complex acquisition. The sole purpose of the transaction was to get away from the limited partnership structure. This triple net lease REIT had historically been a top industry performer, but it always had the stigma of being an LP. Avoiding the potential of tax scrutiny was likely an additional incentive for the deal, and makes W.P. Carry more attractive. 

Other Loopholes To Consider
Of course, if the government looks to close tax loopholes, REITs like W.P. Carry could come under increased scrutiny as well. Indeed, these companies avoid corporate-level taxation by passing along at least 90% of earnings to shareholders, who pay taxes on the distributions at their normal income tax rate. A change here would be a massive issue for everyday investors. And, if REITs get the evil eye of the tax man, so too will business development companies, which have a similar structure.

The purpose of this article isn't to suggest that a tax Armageddon is coming. But there are tax issues that need to be watched when you are dealing with investments that have a tax benefit of some sort. Indeed, the Halloween Massacre of Canadian Royalty Trusts was brutal for many small investors in Canada and the United States, and proves that such changes can happen. And sometimes they happen overnight.

ReubenGBrewer has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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