Congress is considering whether a loophole in the tax code is allowing the managers of hedge funds and private equity firms to sidestep billions in income taxes.
The congressional debate has left many 2008 presidential candidates -- especially the Democratic contenders -- walking a political tightrope. Most White House wannabes have accepted millions of dollars in donations from people who manage hedge funds or work at private equity firms.
Million Dollar Donors, Billion Dollar 'Glitch'
Republican and Democratic presidential candidates received almost $10 million dollars from securities and investment firms in the first three months of the campaign, according to an analysis of Federal Election Commission data by the Center for Responsive Politics.
A Senate Finance Committee hearing Wednesday explores whether managers of hedge funds and private equity firms are getting an unfair tax break from a loophole in the tax law that allows managers of hedge funds and private equity firms to pay only 15 percent tax on the money they make from investments, called "carried interests."
"This is a glitch in the code," said Marc Gergen, a tax law expert from the University of Texas Law School, who is testifying before the committee Wednesday. "These guys are paying 15 percent income tax rates when everybody else is paying about 35 percent."
Gergen said under the current system, personal profit made by private equity and hedge fund partners -- who mostly invest other people's money -- is considered capital gains, which is taxed at a lower rate than personal income. Critics argue this allows the managers to sidestep paying billions of dollars of taxes, including Medicare taxes.
Some in Congress want to double or triple the tax rates the managers currently enjoy and use it to offset the alternative minimum tax that currently hits middle-class Americans.
Republicans Oppose Tax Change
Most of the Republican presidential candidates have come out firmly against any congressional effort to change the status quo.
Former Gov. Mitt Romney, R-Mass., has perhaps the strongest ties to private equity and hedge fund money. He made his fortune -- estimated between $190-$250 million -- in private equity, founding Bain Capital in 1984, a lucrative Boston-based private equity firm.
Romney took in the most money from the sector in the first financial quarter of the presidential campaign, receiving almost $1,925,000 from securities and investment firms, according to an analysis by the nonpartisan Center for Responsive Politics. Data from Romney's second-quarter fundraising haul will be available later this month.
"Gov. Romney does not support this move by Congress," Romney campaign spokesman Kevin Madden told ABC News. "Gov. Romney is opposed to tax increases and believes Congress should instead focus on cutting wasteful government spending."
Popular with Wall Street, former Mayor Giuliani, R-N.Y., has also had success in raising money from securities and investment firms. He took in about $1,840,000 from the sector in the first quarter, according to the Center for Responsive Politics.
Both candidates oppose a proposal in the Senate by Finance Chair Max Baucus, a Montana Democrat, and ranking Republican Charles Grassley of Iowa, to tax publicly traded hedge funds or private-equity partnerships at the same rate as other corporations.
"Mayor Giuliani views the Baucus-Grassley bill as a tax increase, and the last thing we need right now is another tax increase," Giuliani campaign spokeswoman Maria Comella told ABC News.
The Bush administration has criticized the idea of raising taxes on hedge-fund and private-equity managers, suggesting the president might veto such a tax hike.
Democrats Hedge Bets
Democratic presidential candidates have been reluctant to condemn the tax loophole for these elite investment clubs, instead voicing more tepid, general concern.
"The Democratic candidates and their staffs are still trying to determine where they should come down on this," said Paul Brathwaite, a Democratic strategist.
"It may not be as simple as going after a group of rich people," said Brathwaite, arguing Democrats are wary of upsetting the market and want to learn more about the issue before committing to a position during the election.
However, others suggest a big part of their apprehension could be the millions of fundraising dollars they are raising from these private equity and hedge fund managers.
"It's their convictions pitted against their money," said Dan Primack, editor of PEHub.com, a financial Web site. "They've taken in millions from these private equity folks and so the Democrats have a problem."
"The vast majority of private equity folks are dead set against this type of tax change," Primack said.
Sen. Hillary Clinton, D-N.Y., took in almost $1,680,000 from securities and investment firms in the first three months of her campaign -- the most of any other Democratic candidate, according to analysis by the Center for Responsive Politics.
When pressed for the position on the issue, Clinton's press secretary told ABC News last month: "Sen. Clinton believes there are broad concerns surrounding private equity in relation to the rest of the market."
Clinton's campaign took in more than $1 million dollars from a glitzy, Manhattan fundraiser on June 26, where campaign staffers passed out copies of a Fortune Magazine that declared "Business Loves Hillary!" on its cover. Many big name private equity and hedge fund managers attended.
"It's a real tough issue for somebody like her to finesse, because when she's trying to sell herself to these people, if she favors this tax, she is essentially saying to these people, 'I'm in favor of double or tripling your taxes,' and that's a very difficult thing to navigate," said Primack.
Sen. Barack Obama, D-Ill., took in $1,395,000 from investment and securities firms in the first quarter, according to the Center for Responsive Politics.
Obama's Senate press secretary told ABC News that the senator has said in the past that his inclination is to support congressional efforts to close the loophole for hedge funds and private equity firms, based on what he's seen so far.
Other Democratic candidates have also taken in vast sums from the securities and private equity sector. According to the Center for Responsive Politics, Sen. Chris Dodd, D-Conn., raised $1,280,000 from individuals in that group in the first three months of the campaign.
Former Sen. John Edwards of North Carolina, who is running on a platform of closing the gap between the rich and poor in America, released a statement Wednesday saying he firmly supports taxing publicly traded private equity firms and hedge funds at a higher rate.
Edwards, a Democrat, received about $497,000 from investment and securities firms in the first three months of his campaign, according to the Center for Responsive Politics.
Edwards has also gone farther than any other leading Democratic candidate in calling for the elimination of the loopholes that currently allow the managers of these firms to defer taxation by shifting their income offshore.
"You want to know what I mean by Two Americas? A tax code that lets hedge fund and private equity managers making hundreds of millions a year pay taxes at a lower rate than their secretaries is wrong," read a statement released Wednesday by Edwards.
"Building One America means getting rid of loopholes like the one that lets these investment advisers treat most of their compensation as capital gains. Carried interest is compensation for work, and it should be taxed like other pay," the Edwards statement reads.
Edwards' position could put him at odds with his former employer, Fortress Investment Group, a hedge fund that paid Edwards $479,000 in 2006 for working as a consultant before the start of his 2008 campaign bid.
Fortress has reportedly allowed managing partners to avoid paying U.S. income taxes by reinvesting profits in off-shore tax shelters.
The congressional effort to change the tax has been met with a powerful lobbying efforts in Washington. Eleven of the wealthiest private equity firms have joined together to create the Private Equity Council, including Apollo Management, Bain Capital, the Blackstone Group, the Carlyle Group, Hellman & Friedman, Kohlberg Kravis Roberts & Co., Apax Partners, Providence Equity Partners and Silver Lake Partners.
"There is certainly an effort to educate all lawmakers and anyone with an interest in public policy as to what the contributions that private equity has made to economic growth and investors including pension funds," said Robert Stewart, vice president of public affairs for the group.
"If you increase the value of an investment and have made a profit, you've taken a risk, and should be taxed at the same rate as any other partnership is [taxed]," added Stewart.
Venture capitalists -- those firms that invest early on in budding businesses -- are also lobbying against the congressional measure to increase taxes on "carried interests."
"These are people who are investing in two guys in a garage," said Emily Mendell of the National Venture Capital Association. "It's a long-term investment; it's a risky investment and any compensation derived from that should continue to be taxed at the capital gains rate, the same it's always been," she said.
Both lobbying groups said they are not targeting the presidential candidates specifically on the issue.
However, others said the candidates are getting an earful about the issue as they campaign for cash.
"Most major firms have donated serious bucks to the candidates," said Primack.
"One of the reasons why you donated the maximum to a candidate is so you can get that candidate's ear ... I would be stunned if they're not taking full advantage of that and trying to persuade them to oppose this legislation."
ABC News' David Muir and Raelyn Johnson contributed to the report.