Investment managers would have to pay regular income tax on investment earnings if Congress approves President Obama’s Fiscal Year 2013 tax proposal. The controversial “carried interest” tax again has made its way into the White House revenue proposals that go along with its spending plan. Closing that tax loophole was also in Obama’s tax proposals for last year’s budget, but the tax did not make it through the legislative process.

Under current law, the return on a carried interest has the same character as the underlying profits of the fund. Thus, to the extent the fund earns long-term capital gains, the return on the carried interest is taxed at the lower capital gains rate of 15 percent.

A senior Treasury official unveiled the tax plan, called the “Green Book,” at Treasury headquarters Feb. 13.

“By allowing service partners to receive capital gains treatment on labor income without limit, the current system creates an unfair and inefficient tax preference,” the Green Book explanation states, asserting that carried interest should be taxed as ordinary income because such income is derived from the performance of services. “The recent explosion of activity among large private equity firms and hedge funds has increased the breadth and cost of this tax preference, with some of the highest-income Americans benefitting from the preferential treatment.”

The proposal would tax as ordinary income a partner’s share of income on an “investment partnership interest,” regardless of the character of the income at the partnership level, and not be eligible for the reduced rates that apply to long-term capital gains. The proposal would also require the partner to pay self-employment taxes on the income.

The full text of the 208-page Green Book may be accessed here.