A New York Times story by Andrew Ross Sorkin, “Of Private Equity, Politics, and Income Taxes,” discussed pending legislation to change the tax treatment of private equity fees. A post on the blog Conglomerate (which is most assuredly not liberal, I would place it as centrist to somewhat right) has has a series of posts on the same issue, based on a paper, “Two and Twenty: Taxing Partnership Profits in Private Equity Funds,” by Victor Fleischer of the University of Colorado Law School. Fleischer, rather than suggesting closing the private equity loophole, instead offers a menu of reforms, including a novel cost-of-capital approach intended to strike a balance between treating returns on human capital as ordinary income and rewarding entrepreneurial activity with a tax subsidy.
We will leave it to industry lobbyist Douglas Lowenstein to argue why private equity firms are particularly deserving of an entrepreneurial tax subsidy…
We’ll touch briefly on the NYT piece, then go to Fleischer, who has some useful observations.
The Times makes a simple but compelling argument:
Should the 20 percent fees that private equity firms collect from the profits of its investments be considered capital gains, as they are now, or regular income? It’s a giant difference — the tax rate for capital gains is 15 percent, versus 35 percent for regular income.
There’s no doubt about it: the Internal Revenue Service should clearly be considering it regular income. After all, their own money is not at risk — it’s a fee. (By contrast, when they invest their own money in the funds, the profit is obviously a capital gain.)
Let’s be honest: it is a charade that private equity firms have claimed their 20 percent performance fees at the lower capital gains rate. To qualify, they invest a nominal amount of their own money to demonstrate that they have put something at risk, but it’s a ruse. They are paying capital gains rates for doing their job, which should be taxed at the regular income rate.
One wonders why the IRS didn’t pick up on this one long ago.
Fleischer give a more detailed discussion, but his conclusions are generally the same. This quotation is from the abstract of his “Two and Twenty” paper:
Private equity fund managers take a share of the profits of the partnership as the equity portion of their compensation. The tax rules for compensating service partners create a planning opportunity for managers who receive the industry standard “two and twenty” (a two percent management fee and twenty percent profits interest). By taking a portion of their pay in the form of partnership profits, fund managers defer income derived from their labor efforts and convert it from ordinary income into long-term capital gain. This quirk in the tax law allows some of the richest workers in the country to pay tax on their labor income at a low rate. Changes in the investment world – the growth of private equity funds, the adoption of portable alpha strategies by institutional investors, the increased capital gains preference, and aggressive tax planning – suggest that reconsideration of the partnership profits puzzle is overdue.
His post, “Why We Should Change the Tax Treatment of Carry,” goes into more detail.” His main arguments is that limited partnerships were not designed for this particular use, and that the buyout firms have done a very good job of gaming their situation:
….the reasons for change go beyond the politics of resentment…
1. The Source of Capital. As the private equity industry has matured, it has put greater pressure on the partnership tax rules, which were designed with small business in mind. The stakes are higher because funds are larger. And many of today’s funds are backed by tax-exempt LPs (such as pension funds and university endowments), which are indifferent as to the loss of an ordinary deduction for compensation.
2. Regulatory Gamesmanship. Tax planning has become more aggressive. Fund managers nominally receive a mix of management fees, taxed as ordinary income, and carried interest, taxed as capital gain. But several strategies are commonly employed to convert management fees into carry.
First,…a significant portion of carry simply represents the time value of money. Instead of indexing the carry to an interest rate or an industry average, partnership profits are measured from the first dollar of nominal profits, which ignores the cost of capital. The tax rules give fund managers a strong incentive to do this, as carry is tax-advantaged compared to management fees….
Second, fund managers convert management fees into carry on an annual basis. As management fees come due, fund managers waive the fees in exchange for a priority allocation of additional profits. So long as the receipt of these profits is subject to some market risk, the technique is not thought to trigger constructive receipt. And so management fees, which would normally be taxed at 35%, are instead deferred a bit longer and then taxed at a 15% rate.
Third, even the 1-5% GP capital contribution is no longer paid in with after-tax dollars. Instead, GPs use the management fees in the first few years of the partnership to fund the GP capital contribution, creating a so-called “cashless capital contribution.”
In sum, distributive justice isn’t the only reason to reconsider the current rules. The current rules encourage wasteful tax planning, which distort the contract design and increase agency costs between the LPs and GPs.
Fleischer offers his “Reform Alternatives for Taxing Carry:”
One possibility, as noted in Sorkin’s column today, is to tax carry as ordinary income. But there is another method – what I call the “cost-of-capital method” – which might make for better tax policy.
A 20% carry is equivalent to two different economic arrangements: (1) an at the money call option to acquire 20% of the capital of the fund, or (2) a nonrecourse, zero interest rate demand loan of 20% of the capital of the fund, the proceeds of which are used to buy 20% of the capital of the fund. The “right” tax policy depends on which analogy we prefer….
You can find the full paper here.