On January 1, the House of Representatives passed The American Taxpayer Relief Act (the “Act”) which will increase income tax rates on higher-income taxpayers as well as make certain other changes to the Internal Revenue Code. The Senate previously passed the Act and the President is expected to sign it into law.

The Act:

• Increased the top tax rate on ordinary income (including short-term capital gains) to 39.6% for taxpayers with a taxable income of $450,000 or more (married persons filing a joint return) and $400,000 or more (single persons);
• Increased the top tax rate on long-term capital gains and qualified dividend income to 20% for taxpayers with taxable income of $450,000 or more (married persons filing a joint return) and $400,000 or more (single persons);
• Retained the preferential tax treatment for “qualified dividend income,” which will continue to be taxed at the same rates as long-term capital gains;
• Eliminated the temporary 2% reduction in the employee share of Social Security taxes, thereby raising the payroll withholding tax rate back to 6.2% on the first $113,700 of income;
• Reinstated the phase-out of itemized deductions for taxpayers earning more than $300,000 (married persons filing a joint return) or more than $250,000 (single persons) (the so-called “Pease Limitation”);
• Permanently raised the thresholds for the application of the Alternative Minimum Tax and indexed them to inflation;
• Raised the top estate, gift and generation-skipping transfer tax rates to 40% for individuals dying and gifts made after 2012, but retained the lifetime exemption from estate, gift and generation-skipping transfer taxes of $5 million, indexed to inflation from 2010; and
• Extended certain expiring business and individual tax provisions.

These changes will generally result in higher taxes for most taxpayers, regardless of their income level.

Most importantly for the investment management industry, the Act did not change the taxation of “carried interest”. However, the Act also did not raise the federal debt ceiling and only temporarily delayed automatic spending cuts (referred to as “sequestration”). As a result, the new Congress and the President will need to take additional action regarding taxes and/or spending in the first three months of 2013. This potential new round of tax changes could include more significant reforms, including elimination of various deductions and credits, corporate tax reform and changes to the taxation of carried interest (including the “enterprise value tax”).

The extension of the “qualified dividend income” provisions will be helpful to private investment funds in that most dividends from U.S. domestic corporations and foreign corporations which are publicly traded in the United States or organized in a jurisdiction that has a tax treaty with the United States will continue to be eligible to be taxed at the same rates as long-term capital gains.

The reinstatement of the Pease Limitation (which had been temporarily suspended since 2010) on miscellaneous itemized deductions will adversely impact U.S. taxable investors in domestic private investment funds that are “investors” in securities, rather than “traders” in securities. Expenses incurred by these funds (e.g., management fees) will potentially be subject to the Pease Limitation in the hands of U.S. taxable investors.

We will be monitoring legislative developments in this area and will keep you informed of their potential impact on private investment funds. If you have any questions regarding this memorandum, please call Ronald P. Cima at (212) 574-1471, James C. Cofer at (212) 574-1688 or Daniel C. Murphy at (212) 574-1210.