Taxing times

Senior members of the US Senate Finance Committee have been reviewing private equity tax structures in recent months, while public momentum has been building to reevaluate the way in which carried income is taxed. Currently, carried interest is taxed as capital gains at 15 percent, but committee member Chuck Grassley and committee chairman Max Baucus have indicated the designation could be changed to income tax, resulting in a rate of 35 percent.
No legislation has surfaced, but several exploratory, closed-door committee sessions relating to the matter have reportedly occurred, and at least one proponent of GP tax reform, University of Colorado law professor Victor Fleischer, has met with the senate committee.
Meanwhile, the House of Representatives appears to have begun its own investigation. At press time, the president of lobbying group the Private Equity Council and the president of Service Employees International Union, America’s largest labor union, were readying to testify before the House Financial Services Committee as to private equity’s effects.
Though the SEIU has said its interest in buyouts relates primarily to how workers are impacted, it has repeatedly said the industry should “play by the same set of rules as everybody else,” a subset of which it says includes taxes.
PEC’s president, Doug Lowenstein, has chalked up much of the activity on Capitol Hill as fact-finding. Partners from major firms at a recent private equity roundtable in New York voiced similar sentiments, saying they expect more government scrutiny as the industry grows, and while hard to argue with the logic fueling the tax debate – that it’s unfair to treat carried interest as capital gains considering it isn’t technically the GP’s capital being risked – they
certainly intend to, if push comes to shove.
David Rubenstein, The Carlyle Group co-founder, said: “I think Congress is now looking for revenue because they’ve got some holes to fill and private equity – because it’s gotten so much publicity – is an attractive source of potential revenue.”
Speaking at the 10th annual Milken Institute Global Conference in Los Angeles, Rubenstein likened a would-be change in private equity partnership taxation – taxation that applies to all types of partnerships – to the Alternative Minimum Tax legislation, via the Tax Return Act of 1976. The Act was meant to tax a couple hundred wealthy families and now affects ten of millions of middle class Americans. “I think you’ll have the law of unintended consequences, and you’ll probably have people doing things that aren’t really that desirable,” Rubenstein said.
To help shape the debate, he said, the industry must do a better job of explaining itself and highlight the fact that public pension funds are primary beneficiaries of private equity investments.
But positive PR isn’t the only avenue for avoiding a higher tax rate, according to a report recently published by La Jolla Economics.
The Southern California-based economic consulting firm contends GPs can protect their carry by following The Blackstone Group’s lead and booking option values upfront, in compliance with new accounting standard SFAS 159: “So by going public they can cash out at the 15 percent tax rate as opposed to 35 percent,” LJE said. The downside, it added, is the option value is updated and adjusted at an exit, which could result in a loss to the IPO’s investors.
The argument may factor in significantly as the industry grapples with how to best unlock the franchise values of management companies, create permanent capital, and attract and retain talent.
But how long a public offering’s tax advantages last may be the more salient question. The Internal Revenue Service and US Treasury have reportedly launched an associated inquiry.