With Tax Advantages Looking Shaky, Private Equity Seeks a New Path

As Washington grapples with the country’s fiscal woes, the private equity industry is grudgingly facing a new reality: its long-held tax advantages are likely to disappear.

For years, private equity has quashed efforts to raise taxes on so-called carried interest income, the profits partners receive as part of their compensation. Those earnings are considered capital gains, so they are taxed at a much lower rate than ordinary income.

While few concede defeat publicly, the industry is rethinking its strategy. Rather than trying to stop the changes outright, lawyers and executives behind the scenes are trying to minimize the hit if it happens.

Private equity recognizes the shifting politics. In the current budget debate, sacred cows like the tax deductions for home mortgage interest and charitable donations are on the table, alng with potential cuts to Social Security and Medicare.

“Once they start looking for revenues, carried interest will be on the list,” said Anne Mathias, director of Washington policy research at Guggenheim Partners, a financial services firm. “You can hear it already: ‘We need that money, or Grandma won’t get a new hip.’ ”

Democrats and Republicans alike are looking at eliminating loopholes as part of a broader effort to overhaul the tax code. Changes to the treatment of carried interest could bring in $17 billion over 10 years, according to Congressional estimates.

“There is ! absolutely no reason why income earned for managing other people’s money shouldn’t be taxed in the same way as income earned teaching or working in a factory,” said Representative Sander M. Levin, Democrat of Michigan, who introduced the latest carried interest bill in 2012. Legislation based on Mr. Levin’s bill is likely to be part of a broader package if carried interest comes into play.

Officially, the private equity industry remains opposed to change. Its lobbying group, the Private Equity Growth Capital Council, began an extensive public relations campaign last year to improve the industry’s image during the presidential race, in which the Republican candidate, Mitt Romney, was criticized for his actions as chief executive of the private equity firm Bain Capital.

The trade group also increased its ongressional lobbying. To highlight the industry’s economic contributions, it arranged 70 meetings in which House members visited private-equity-owned companies or met their chiefs. For example, Representative Robert Hurt, Republican of Virginia, toured a distribution center for Dollar General, a retailer previously owned by Kohlberg Kravis Roberts.

“We will continue to do what we have always done,” said Steve Judge, chief executive of the trade group.

He and others argue that it is appropriate to treat private equity income as capital gains because managers have money at risk and actively reorganize companies. Mr. Judge also noted t! hat priva! te equity is already paying more under the deal to avert the fiscal cliff, which raised the capital gains tax rate to 20 percent from 15 percent, on top of the 3.8 percent capital gains surcharge enacted on wealthy taxpayers to finance President Obama’s health care law.

But even as the industry continues to press its case, many of its members acknowledge that the carried interest break is coming to an end. “At some point it’s inevitable, so they will deal with it,” said Bradley Morrow, a senior private markets consultant at Towers Watson. If the proposal does re-emerge, the industry is expected to focus its lobbying on softening transition rules.

One issue will be the amount of carried interest reclassified as ordinary income. Mr. Levin’s2012 bill would convert 100 percent of carried interest. By contrast, an earlier version of the bill proposed capping the affected income at 50 percent to 75 percent.

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, said Micah W. Bloomfield, a tax lawyer with Stroock & Stroock & Lavan. That would give partners more time to pocket capital gains or restructure funds before the rate increase took effect.

Another point of contention will be the treatment of profits that partners earn when they sell stakes in their firms, a sum known as enterprise value. Currently, profits attributable to enterprise value are treated as capital gains. In earlier bills, they would have been reclassified as ordinary income.

“What people complained most vociferously about in the earlier bills was the treatment of enterprise value,” said James R. Brown, a tax lawyer with Willkie Farr & Gallagher. If a fund manager sold the business, “all the gain from the sale would have been considered ordinary income,” Mr. Brown said. “That’s a big difference in how any other business is taxed when it’s sold.”

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. The issue is particularly important for large, publicly traded firms like Blackstone and K.K.R. As partners near retirement, they see it as crucial to get capital gains tax treatment when they divest their stakes.

But the issue is complex. Congressional tax staff, worried that firms could redefine some carried interest as enterprise value, wrote the language of the bill narrowly to prevent abuse.

Private equity advocates arguethat the bill still casts too wide a net, and that some legitimate profits from business sales would end up classified as ordinary income.

“They may think they have solved the issue, but they haven’t,” said one industry lobbyist, who requested anonymity because of the delicacy of the discussions.

Beyond transition rules, firms might consider adapting their own structures if the break does end.

The simplest strategy â€" one already occurring â€" is to accelerate the recognition of accrued capital gains. Funds might also remove some unrealized carried interest from their investment partnerships altogether, said Steven Rosenthal, a visiting fellow at the Washington-based Tax Policy Center. They could do that by shifting ownership of the gains to an affiliate by distributing securities of equal value.

These ideas may not all work, but funds are preparing nonetheless. Many have added language to partnership agreements, reserving the right to restructure, Mr. Brown said.

Tax lawy! ers have been searching for a broader escape hatch for years, in something of a cat-and-mouse game with legislators. In one early proposal, the lawyers suggested that general partners borrow money from limited partners to help capitalize a fund. They also explored setting up funds using foreign corporations that allow income to flow through to their owners as capital gains. But legislators rejected those ideas in later bills.

A potential strategy still being discussed involves setting up new funds as America-based C corporations, which the Internal Revenue Service taxes separately from their owners. In one possibility, a 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 private quity 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.

The structure is similar to one used in venture capital, said Patrick B. Fenn, a tax lawyer with Akin Gump Strauss Hauer & Feld. “People are looking at this, but no one has gotten to the point where they’d do it for their next fund,” Mr. Fenn said. “You won’t see any real reaction on structures until we see the specifics.”

Added Mr. Morrow of Towers Watson: “There are a number of ideas on the drawing boards. I’m not sure any of them will work, but the tax lawyers and accountants are certainly working on it.”