Happy Tax Day. April 15 is a good day to reflect on how much you pay in taxes and what you receive in return. It’s also good to think about how your tax rate compares with what your friends, neighbors and colleagues pay.
If any of those people work in private equity, (1) they probably won’t tell you their tax rate. Here are 10 reasons it’s lower than yours:
Carried Interest. In exchange for managing an investment fund, managers receive a percentage of the fund’s profits, known as carried interest. The amount of carried interest is typically 20 percent, and in any given year, individual fund managers earn anywhere from nothing to tens of millions of dollars. Under current law, if the fund’s profits are capital gains, the manager’s carried interest is also taxed at capital gains rates. Proposed legislation would treat this income as ordinary income, like other types of labor income.
How to fix it: Pass the carried interest legislation.
Management Fee Waivers. Fund managers also receive a fixed management fee, often 2 percent of capital, for managing the fund. Management fees are normally taxed as ordinary income. To avoid this, some fund managers periodically waive their fees in exchange for an almost-risk-free priority allocation of profits taxed at capital gains rates.
How to fix it: Enforce current law. My view is that fee waivers rarely involve enough risk to avoid being recharacterized as ordinary income.
The Limited Partner Loophole. As labor income, management fees would normally be subject to the Medicare tax, now 3.8 percent for high-income individuals. Under current law, even investment income is subject to the 3.8 percent tax. Through careful structuring, some fund managers take their income through a limited partnership in which they are technically “limited partners†in the management company, even though it is their labor, and not their capital, that generates the fee income. Allocations to limited partners, however, are neither subject to the Medicare tax as self-employment income nor as investment income under section 1411.
How to fix it: Amend section 1402, as recommended by the tax section of the New York State Bar Association.
The S Corp Loophole. This is conceptually the same as the limited partner loophole: wages are funneled through an S Corporation to avoid employment taxes.
How to fix it: Make all S Corporation income subject to the 3.8 percent Medicare Tax.
Private Equity Publicly Traded Partnerships. Normally, publicly traded companies are taxed as corporations, which means that shareholders pay both an entity-level tax and also a shareholder-level tax on dividends or capital gains. But when the Fortress Investment Group, the Blackstone Group, the Carlyle Group and other investment firms went public, they used the favorable tax treatment of carried interest (which is treated as investment income, not labor income) to squeeze into an arcane exception to the publicly traded partnership rules for “qualifying income,†which includes investment income. So publicly traded private equity firms, unlike investment banks, avoid the corporate tax altogether.
How to fix it: Pass the carried interest legislation.
Supercharged public offerings Private equity firms that went public structured the initial public offerings to resemble a sale of the firm’s assets to the newly public company, creating for the public company a new, higher “cost basis†in the firm’s assets. The value of those assets attributable to the goodwill of the firm could then be amortized over 15 years, generating new tax deductions at a 35 percent rate. As part of the deals, the newly public companies entered into tax receivable agreements, in which the companies promise to pay 85 percent of the tax benefits back to the selling founders
In short, not only did the founders pay tax on the sale at low capital gains rate, they get a check each year from the newly public companies to thank them for doing so.
How to fix it: Change the rules for taxing the sale of a partnership interest.
Enterprise Value. If the carried interest legislation were passed, individual managers may try to cash out by selling their carried interests to a third party and recognizing capital gain. The proposed legislation closes that loophole, but still allows the managers to sell interests in the management company â€" most of the value of which is attributable to past and future carried interest income and management fees â€" at capital gains rates. While I understand the political necessity to cede this issue, in a better world I’d suggest taxing more of the value of those partnership interests as “hot assets†that give rise to ordinary income when sold.
How to fix it: Change the rules for taxing the sale of a partnership interest.
The Angel Investor Loophole. Section 1202 allows investors in “qualified small business stock,†mostly angel investors and venture capitalists, to exclude 100 percent of their capital gains, in most cases up to $10 million.
How to fix it: Repeal Section 1202.
I.R.A. Stuffing. Fund managers sometimes take partnership interests or shares in underlying portfolio companies and contribute those interests to I.R.A.’s at artificially low valuations. Once the interests are inside the I.R.A., appreciation in the value of the investments goes untaxed until distributed.
How to fix it: Limit I.R.A. investments to actively traded securities.
Interest Deductions. Right at the core of the private equity business model is taking a company private, loading it up with debt that was used to finance the acquisition and using the interest deductions to shield the portfolio company from tax liability.
How to fix it: A Harvard Business School professor, Robert C. Pozen, has suggested disallowing 30 percent of interest deductions. My own preference would be to level the playing field between the tax treatment of debt and equity.
“Tax reform will close special-interest loopholes to help lower rates,†said Senator Max Baucus, the chairman of the Senate Finance Committee, and Representative Dave Camp, the chairman of the House Ways and Means Committee, in a recent Wall Street Journal opinion article. Mr. Baucus and Mr. Camp have led a great process thus far. Let’s keep this column as a scorecard and see how they’re doing in six months.
Victor Fleischer is a professor at the University of Colorado Law School, where he teaches partnership tax, tax policy and deals. Twitter: @vicfleischer
