During a pre-Super Bowl interview on CBS Sunday evening President Obama once again raised the issue of “carried interest”–a share of a partnership’s profits that’s taxed at capital gains rates rather than at higher, ordinary income rates–as part of a larger discussion about closing loopholes in the federal tax code.

There will be no call from the administration for further rate increases, but more revenue will be sought, in addition to “smart” spending cuts, to help close the budget deficit.

At the top of the wish list is an item that’s highlighted tax policy debates since 2007, when three high-profile initial public offerings (IPO) by big private equity firms drew new scrutiny to provisions of the prevailing regime that seem to bring unwarranted advantages to wealthy taxpayers.

The term “carried interest” isn’t defined in the Internal Revenue Code (IRC) or in US Treasury Dept regulations promulgated under it.

A carried interest generally refers to an interest in partnership profits that a general partner (GP) or manager in limited partnerships (LP) and limited liability corporations (LLC) receives in exchange for services. It is a standard form of compensation.

In addition to its carried interest, a GP or manager may invest capital in a partnership along with other investors. As commonly used, the term “carried interest” refers to a share in profits beyond that returned to the GP or manager for equity it invests in the partnership.

Limited partnerships have no carried interest. For GPs of energy master limited partnerships (MLP), carried interest includes the incentive distribution rights (IDR) paid for performance, which is typically about 2 percent. This income, however, has been taxed all along at ordinary rates, as it’s derived from operating rather than investing activities.

Carried interest is often used as a way to compensate hedge fund and private equity managers for services they provide. Because hedge funds and private equity funds are organized as partnerships, the managers’–or general partners’ (GP)–share of the earnings has the same character as it does for the partnership that earns it.

For many hedge funds and private equity funds, a principal source of income is buying and selling the stock of other companies.

The traditional performance fee of 20 percent of earnings–the latter part of the typical hedge fund/private equity arrangement whereby investment managers offer their services in exchange for 2 percent of the annual value of the partnership assets as an annual management fee (“to keep the lights on”) and 20 percent (but, in the case of hedge funds, as low as 15 percent and as high as 50 percent) of the eventual profits (to compensate them for their investment acumen)–is also capital gains in their hands.

“Carried interest” is, basically, payment for managing other people’s money.

Financial MLPs, which closely resemble hedge funds and private equity firms, do seem to be in the crosshairs of both the president and influential members of Congress.

“There continues to be no rationale whatsoever for people to pay at a vastly lower tax rate when they are managing other people’s money,” Rep. Sander Levin (D-MI), the ranking minority member on the tax-writing House Ways and Means Committee, said on Bloomberg TV recently. “This is an issue of fairness that we should address as we seek a balanced approach to deficit reduction that involves both additional revenues and spending cuts.”

Mr. Obama’s most recent budget proposal includes such a change, which according to the Joint Committee on Taxation of the US Congress would raise about USD16.8 billion over 10 years.

In the budget deal reached on Jan. 1 that averted most of the USD600 billion in tax increases and spending cuts scheduled to take effect in 2013–the so-called fiscal cliff–lawmakers increased the top rate on long-term capital gains to 20 percent from 15 percent and the maximum rate on ordinary income to 39.6 percent from 35 percent.

The big rate differential between capital gains and ordinary income makes it likely that carried interest could lose its preferential tax treatment.

Opponents of any targeted attempt to close the so-called carried interest loophole will point out that those who benefit from it are already poised to pay significantly more into federal coffers going forward than they did prior to 2013.

The 2010 health care law tacks an additional 3.8 percent surtax on investment income of high earners starting this year, bringing the maximum rate to 23.8 percent from 15 percent. That’s a 59 percent increase.

And for private equity managers, a change to the treatment of carried interest could have a much bigger effect. If carried interest were taxed as ordinary income, the top rate on such profits would increase to 39.6 percent. High-income taxpayers also face a 0.9 percent added tax on wages starting this year as a result of the health care law. That means the top rate would be 40.5 percent compared to 23.8 for capital gains, or a 70 percent rise.

If anything is done in coming months, it’s unlikely that all amounts characterized as carried interest will be taxed entirely at ordinary income rates. A bill crafted by Mr. Levin in 2012 bill would convert 100 percent of carried interest. However, an earlier version of the bill proposed capping the affected income at 50 percent to 75 percent.

If tax law changes are made affecting carried interest, hedge fund and private equity managers could sell investments that have gained in value or restructure partnerships before new rules take effect. During 2012 some private equity managers refinanced investments, accelerated gains on deals and shifted what they transferred to trusts.

Hedge funds and private equity firms will also push for an extended implementation period, even if it means a reduced or even no cap on the amount of carried interest taxed at ordinary rates. A long delay in an effective date for new treatment would allow financial partnerships time to book capital gains at the advantaged rates and/or to restructure funds in a way that limits future tax liability.

The industry is also likely to focus on how quickly any changes would go into effect. Lobbyists will probably push for a longer delay, even if it means little or no cap. That would give partners more time to pocket capital gains or restructure funds before the rate increase took effect.

Another point of negotiation will be the treatment of profits that partners earn when they sell stakes in their firms, known as “enterprise value.” Enterprise value profits are treated as capital gains under the current regime. In earlier bills such profits would have been reclassified as ordinary income.

The Obama administration and Congressional proponents of reform acknowledge the problem. Mr. Levin’s latest bill included provisions to treat enterprise value as capital gains. As partners in hedge funds and private equity firms near retirement, they see it as crucial to get capital gains tax treatment when they divest their stakes.

The simplest strategy to avoid potential higher rates of taxation–put into motion in 2012, ahead of anticipated increases in the capital gains rate–is to accelerate the recognition of accrued capital gains. Funds might also remove some unrealized carried interest from their investment partnerships altogether by shifting ownership of the gains to an affiliate by distributing securities of equal value.

Lawyers and accountants for hedge funds and private equity firms are working the problem. One potential solution would see the establishment of new funds as US-based C corporations, which the Internal Revenue Service taxes separately from their owners. A hedge fund or private equity firm would create a corporate holding company to buy and manage each individual portfolio company, instead of buying them through a partnership.

The hedge fund or private equity partners would then receive holding company shares, rather than being paid with carried interest. The private equity managers would pay ordinary income taxes on the initial share distribution, but any further increase in the shares’ value would be considered capital gains. This is a structure similar to vehicles used by venture capital firms.

The impact of any change to the tax treatment of carried interest will vary based on investment activities specific to the entity. But it’s safe to say hedge funds, private equity firms and financial MLPs will, at the very least, be forced to accelerate some profit realizations and effect restructurings of some vehicles, which will involve above-forecast costs. And the reaction in the marketplace is likely to be overly dramatic, whether industry lobbyists successfully argue for inclusion of caps on amounts of carried interest to be taxed at ordinary rates and an extended implementation period or not. And, of course, unit prices of all of them will suffer significantly should the carried interest loophole be close entirely. It’s hard to assess at this point the impact on financial MLP distributions.

We won’t know if and until legislation passes just exactly what the new tax rates will be. And it’s likely at least some of the MLPs that are affected will be able to restructure in a relatively painless way. But setting aside this lingering controversy, distributions paid by the financials in the MLP Profits coverage universe have been volatile, at best, in the aftermath of the Great Financial Crisis. This is reason enough for conservative, income-seeking investors to steer clear of the group.