By Jerri-Lynn Scofield, who has worked as a securities lawyer and a derivatives trader. She is currently writing a book about textile artisans.
The New York Times published a comprehensive piece Saturday discussing how the private equity industry avoids taxes, Private Inequity: How a Powerful Industry Conquered the Tax System.
Regular readers won’t be surprised by any of the article’s revelations about these shenanigans, particularly over the carried interest loophole, a subject Yves has covered extensively, along with her broader coverage of the private equity industry (see, for example, this April post, Private Equity and Hedge Fund Barons Having a Hissy Over Carried Interest Grift Because Biden Isn’t Staying Bought):
Tax professional cringe when normies use the term carried interest in the manner that has become pervasive in the fund management industry. What is called carried interest in the US is not actually “carried interest,” which comes about when a participant in a deal borrows money (typically from other principals) to buy his equity stake. Instead, what the press widely calls carried interest is a profits interest that gets preferential tax treatment. As we explained in 2015:
The reason the “carried interest” label is a misnomer relates directly as to why it is also a tax abuse. Money managers like private equity and hedge funds enter into fee arrangements that include what the IRS calls a “profits interest” and a layperson would describe as a profit share. These firms enter into a prototypical “2 and 20” fee structure, meaning a management fee of 2% per annum of the committed capital plus 20% of the profits, usually after a hurdle rate is met.
Due to clever tax structuring, that 20% is taxed at a capital gains rate even though the managers have no or only a token amount of capital at risk (as in the investors generally require that the fund manager invest some of his capital alongside that of the investors, but it is typically in the 1% to 3% range, and in many cases, that amount isn’t actual cash, but instead a deferral of some of that 2% management fee, which by definition is excessive if the manager is in a position to defer it.). In other words, they are being taxed at a preferential capital gains rate on what by any commonsense standard is ordinary income and should be taxed at ordinary income rates.
To underscore the key point: the carried interest loophole allows private equity and hedge fund honchos to have their labor income taxed at more favorable capital gains rates. That preferential treatment is the reason someone going into asset management is twice as likely as someone going into tech to become a billionaire.
The NYT takedown is well worth a read as it sets out in considerable detail the strategies private equity firms and their executives employ to minimize their taxes.
A couple of issues. The rationale for taxing carried interest at a lower rate is that part of the investment at risk. But as Yves points out above, that’s not actually true.
She was also not fooled by the noises Biden has made to close the carried interest loophole. The NYT article – from which I’ll quote extensively below – offers details on how Democrats and Republicans alike have whiffed on previous reform efforts. That means I too wouldn’t bet the farm on the prospects for closing the carried interest loophole anytime soon.
The NYT piece tells the story of how over the past decade the private equity industry got even greedier. How? In seeking also to reclassify their “management fee” – that 2% levied on investments in their funds – as capital gains rather than ordinary income. That seems outrageous on its face. Yet the industry has largely succeeded in getting that interpretation accepted:
One day in 2011, Gregg Polsky, then a professor of tax law at the University of North Carolina, received an out-of-the-blue email. It was from a lawyer for a former private equity executive. The executive had filed a whistle-blower claim with the I.R.S. alleging that their old firm was using illegal tactics to avoid taxes.
The whistle-blower wanted Mr. Polsky’s advice.
Mr. Polsky had previously served as the I.R.S.’s “professor in residence,” and in that role he had developed an expertise in how private equity firms’ vast profits were taxed. Back in academia, he had published a research paper detailing a little-known but pervasive industry tax-dodging technique.
Private equity firms already enjoyed bargain-basement tax rates on their carried interest. Now, Mr. Polsky wrote, they had devised a way to get the same low rate applied to their 2 percent management fees.
The maneuver had been sketched out a few years earlier by the Silicon Valley law firm Wilson Sonsini Goodrich & Rosati, in a 48-page presentation filled with schematic diagrams and language that only a finance executive could love. “Objective,” one slide read. “Change Management Fee economics to achieve Carried Interest tax treatment, without reducing GP cash flow or adding unacceptable risk.”
In a nutshell, private equity firms and other partnerships could waive a portion of their 2 percent management fees and instead receive a greater share of future investment profits. It was a bit of paper shuffling that radically lowered their tax bills without reducing their income.
The technique had a name: “fee waiver.”
Soon, the biggest private equity firms, including Kohlberg Kravis Roberts, Apollo Global Management and TPG Capital, were embedding fee-waiver arrangements into their partnership agreements. Some stopped using fee waivers when they became publicly traded companies, but the tax-avoiding device remains in wide use in the industry.
“It’s like laundering your fees into capital gains,” said Mr. Polsky, whose paper argued that the I.R.S. could use longstanding provisions of the tax code to crack down on fee waivers. “They put magic words into a document to turn ordinary income into capital gains. They have zero economic substance, and they get away with it.”
As the article goes on to explain, eventually three whistle-blowers would contact Polsky. Why? They were concerned that the structures were dodges. And whistleblowers typically receive a portion of whatever the IRS recovers as a result of any tipoff:
The whistle-blowers — whose previously undisclosed claims are not public but were reviewed by The Times — had independently obtained dozens of private equity and venture capital firms’ partnership agreements from former colleagues in the industry, laying out the fee waivers in great detail.
The arrangements all had the same basic structure. Say a private equity manager was set to receive a $1 million management fee, which would be taxed as ordinary income, now at a 37 percent rate. Under the fee waiver, the manager would instead agree to collect $1 million as a share of future profits, which he would claim was a capital gain subject to the 20 percent tax. He’d still receive the same amount of money, but he’d save $170,000 in taxes.
The whistle-blowers, two of whom hired Mr. Polsky to advise them, argued that this was a flagrant tax dodge. The whole idea behind the managers’ compensation being taxed at the capital gains rate was that they involved significant risk; these involved almost none.
Many of the arrangements even permitted partners to receive their waived fees if their private equity fund lost money.
Prompted at least in part by the whistle-blower claims, the I.R.S. began examining fee waivers at a number of private equity firms, according to agency documents and lawyers who represented the firms.
This would be the last time the I.R.S. seriously examined private equity, and it would not amount to much.
Carried Interest Reform: A Bipartisan Fiasco
Despite ongoing sturm und drang about carried interest and private equity taxation, when changes have been enacted, they’ve loosened rather than tightened the regulatory framework. Political pressure has been deployed to defang rules that agency staffers may propose. Initiatives from both sides of the aisle have followed this pattern.
Before Biden, the last Democratic administration mulled cracking down on carried interest. But readers won’t be surprised to learn of the lack of follow through on these musings. Over to the NYT:
Early in his first term, President Barack Obama floated the idea of cracking down on carried interest.
Private equity firms mobilized. Blackstone’s lobbying spending increased by nearly a third that year, to $8.5 million. (Matt Anderson, a Blackstone spokesman, said the company’s senior executives “are among the largest individual taxpayers in the country.” He wouldn’t disclose Mr. Schwarzman’s tax rate but said the firm never used fee waivers.)
Lawmakers got cold feet. The initiative fizzled.
Quelle surprise! When Democrats finally roused themselves to action, they’ve actually made things worse. I don’t this was any accident; however you may disagree. According to the NYT:
In 2015, the Obama administration took a more modest approach. The Treasury Department issued regulations that barred certain types of especially aggressive fee waivers.
But by spelling that out, the new rules codified the legitimacy of fee waivers in general, which until that point many experts had viewed as abusive on their face.
To the frustration of some I.R.S. officials, private equity firms now had a road map for how to construct the arrangements without running afoul of the government. (The agency continued to review fee waivers at some firms where whistle-blowers had raised concerns.)
]The Treasury secretary at the time, Jacob Lew, joined a private equity firm after leaving office. So did his predecessor in the Obama administration, Timothy F. Geithner.
The NYT described the reactions of IRS agents to this situation:
Inside the I.R.S. — which lost about one-third of its agents and officers from 2008 to 2018 — many viewed private equity’s webs of interlocking partnerships as designed to befuddle auditors and dodge taxes.
One I.R.S. agent complained that “income is pushed down so many tiers, you are never able to find out where the real problems or duplication of deductions exist,” according to a U.S. Government Accountability Office investigation of partnerships in 2014. Another agent said the purpose of large partnerships seemed to be making “it difficult to identify income sources and tax shelters.”
The Times reviewed 10 years of annual reports filed by the five largest publicly traded private equity firms. They contained no trace of the firms ever having to pay the I.R.S. extra money, and they referred to only minor audits that they said were unlikely to affect their finances.
Current and former I.R.S. officials said in interviews that such audits generally involved issues like firms’ accounting for travel costs, rather than major reckonings over their taxable profits. The officials said they were unaware of any recent significant audits of private equity firms.
What about the Republicans? Trump initially promised to get tough on carried interest. According to the NYT:
As a presidential candidate, Mr. Trump vowed to “eliminate the carried interest deduction, well-known deduction, and other special-interest loopholes that have been so good for Wall Street investors, and for people like me, but unfair to American workers.
Readers won’t be surprised that Trump didn’t follow through on this promise either. Per the NYT:
But his administration, stocked with veterans of the private equity and hedge fund worlds, retreated from the issue.
In 2017, as Republicans rushed through a sweeping package of tax cuts, Democrats tried to insert language that would recoup some revenue by collecting more from private equity. They failed.
“Private equity weighs in so consistently and so aggressively and is always saying that Western civilization is going to end if they have to pay taxes annually at ordinary income rates,” said Mr. [Ron] Wyden, an Oregon Democrat.
While White House officials claimed they wanted to close the loophole, congressional Republicans resisted. Instead, they embraced a much milder measure: requiring private equity officials to hold their investments for at least three years before reaping preferential tax treatment on their carried interests. Steven Mnuchin, the Treasury secretary, who had previously run an investment partnership, signed off.
It was a token gesture for an industry that, according to McKinsey, typically holds investments for more than five years. The measure, part of a $1.5 trillion package of tax cuts, was projected to generate $1 billion in revenue over a decade.
Private equity cheered. One of the industry’s top lobbyists credited Mr. Mnuchin, hailing him as “an all-star.”
Mr. [Victor] Fleischer, who a decade earlier had raised alarms about carried interest, said the measure “was structured by industry to appear to do something while affecting as few as possible.”
So, the entire legislative charade was merely an exercise in kayfabe. Nonetheless, Treasury had to flesh out the legislative language with precise rules. It took more than two years to propose any. And then, according to the NYT:
… The Treasury’s suggested language was strict. One proposal would have empowered I.R.S. auditors to more closely examine internal transactions that private equity firms might use to get around the law’s three-year holding period.
The industry, so happy with the tepid 2017 law, was up in arms over the tough rules the Treasury’s staff was now proposing. In a letter in October 2020, the American Investment Council, led by Drew Maloney, a former aide to Mr. Mnuchin, noted how private equity had invested in hundreds of companies during the coronavirus pandemic and said the Treasury’s overzealous approach would harm the industry.
The rules were the responsibility of Treasury’s top tax official, David Kautter. He previously was the national tax director at EY, formerly Ernst & Young, when the firm was marketing illegal tax shelters that led to a federal criminal investigation and a $123 million settlement. (Mr. Kautter has denied being involved with selling the shelters but has expressed regret about not speaking up about them.)
On his watch at Treasury, the rules under development began getting softer, including when it came to the three-year holding period.
In December, a handful of Treasury officials working on the regulations told Mr. Kautter that the rules were not ready. Mr. Kautter overruled his colleagues and pushed to get them done before Mr. Trump and Mr. Mnuchin left office, according to two people familiar with the process.
On Jan. 5, the Treasury Department unveiled the final version of the regulations. Some of the toughest provisions had vanished. Among those was the one that would have allowed the I.R.S. to scrutinize transactions between different entities controlled by the same firm. The result was that it became much easier to maneuver around the three-year holding period.
The government caved,” said Monte Jackel, a former I.R.S. attorney who worked on the original version of the proposed regulations.
Mr. Mnuchin, back in the private sector, is starting an investment fund that could benefit from his department’s weaker rules.
The Hapless IRS
Within this deliberately inadequate framework, the outgunned, outmanned IRS fights what seems to be a never-ending series of losing battles.The article drills down into two areas in particular. The first: who gets audited? Answer: not private equity. Over to the NYT:
While intensive examinations of large multinational companies are common, the I.R.S. rarely conducts detailed audits of private equity firms, according to current and former agency officials.
Such audits are “almost nonexistent,” said Michael Desmond, who stepped down this year as the I.R.S.’s chief counsel. The agency “just doesn’t have the resources and expertise.”
One reason they rarely face audits is that private equity firms have deployed vast webs of partnerships to collect their profits. Partnerships do not owe income taxes. Instead, they pass those obligations on to their partners, who can number in the thousands at a large private equity firm. That makes the structures notoriously complicated for auditors to untangle.
Increasingly, the agency doesn’t bother. People earning less than $25,000 are at least three times more likely to be audited than partnerships, whose income flows overwhelmingly to the richest 1 percent of Americans.
Second, on the rare occasions the IRS does audit a private equity executive, IRS auditors apparently lack sufficient training and expertise to achieve a win for the government. Per the NYT:
Kat Gregor, a tax lawyer at the law firm Ropes & Gray, said the I.R.S. had challenged fee waivers used by four of her clients, whom she wouldn’t identify. The auditors struck her as untrained in the thicket of tax laws governing partnerships.
“It’s the equivalent of picking someone who was used to conducting an interview in English and tell them to go do it in Spanish,” Ms. Gregor said.
The audits of her clients wrapped up in late 2019. None owed any money.
Ouch. Although I don’t think it was prudent for Gregor to be quoted as describing auditors – with whom she may have future dealings – as “untrained.”
What Could Be Done?
As I mentioned above, raising the tax rate on capital gains so that it’s closer to the top rate on ordinary income would reduce or eliminate many of the particular private equity strategies analyzed in this NYT article. The effect would extend beyond the narrow universe of private equity to include all long-term investments. It would also produce other benefits for the U.S. economy, as Yves wrote in April:
Getting rid of the preferential treatment of capital gains is the biggest step Biden could take to reduce the income and wealth gap between the rich and the rest of us. That plus imposing a financial transactions tax would have the salutary effect of cutting the economically unproductive asset management business down to size. Sadly we are a long way away from seeing these changes implemented.
Whether or not Biden takes on the capital gains challenge, he might surprise us and manage to pass legislation that closes the carried interest loophole. What would that mean for the take-home pay of private equity barons? As Yves wrote in her April post:
In fact, top tax experts have been telling private equity fund managers for many years that the carried interest loophole would be eliminated, it was just a matter of how long it would take. The same experts tell us that getting rid of the carried interest abuse isn’t a serious threat to these money managers’ incomes, because they can use other structures to achieve similar ends. That’s why the CBO scores the income from ending the carried interest tax break at only $14 billion over 10 years.
So why aren’t these funds getting out of the way of the inevitable, particularly since it’s not hard to imagine that the private equity firms’ tax gurus would find ways to cut the cake even more in the fund managers’ favor in the new tax gimmickry? They don’t want to be told what to do.
As part of any legislation, Congress could provide further direction to the IRS as to what appropriate audit priorities might be. These could be simple: follow the money!
Some of the IRS staffing and training issues could be fixed by allocating more money to the agency. But this change would require time before its impact would be felt.
Part of the general problem is that the U.S. system of taxation (and financial regulation in general, for that matter) is rules-based. Lots of creative lawyering and other thinking goes into structuring transaction so that they follow the rules. If the taxpayer can demonstrate that a structure conforms to the letter of the rules, s/he survives the audit, no matter how obviously abusive that structure might be.
The UK takes another approach. Its system is principles-based. What that means: an Inland Revenue examiner can tear up a structure that sails too close to the wind. The effect of this difference is to make at least some UK private equity firms and their executives more leery of being as aggressive in pushing the carried interest envelope — or other envelops for that matter – as their U.S.counterparts. Although I have also been told that some UK firms have in fact pushed the most aggressive fee waiver structures.
There was much discussion at the time of deliberations over what became the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act of embodying more principles-based concepts into U.S. financial regulation. These went nowhere. But incorporating them into the U.S. tax code – at least in theory – might give the outgunned, outmanned IRS tools for shutting down the worst tax abuses.
Whom am I kidding?
The extensive quotations from the NYT article I included above show that most if not all of the key players who designed and implemented the current system knew exactly what they were doing. And they’re no doubt pleased with the results.