The list of bad tax reform ideas aimed at the private equity industry is growing. The good news is that the dysfunction in Washington has prevented any damaging tax changes from becoming law, leaving time for the industry to engage and make its case. It is not just US Treasury Department recommendations for revenue “reform” that should worry private equity, it is also the ill-advised ideas of various members of Congress from both parties. Private equity managers need to pay attention and engage because the foundation is being laid now for higher taxes and compliance costs.
Not only is the partnership structure under attack, the long term rates on capital gains and the interest deduction for debt are also genuine targets. If Dodd-Frank did not teach the industry that there is a heavy cost to letting the private equity industry be branded by only the biggest players, then the tax debates will provide a very expensive refresher course on why that is a really bad idea.
If you polled a dozen Treasury or Congressional tax reformers about their top priorities, I bet there would be a variety of responses. Some would say “fairness,” others would say “economic impact,” a few would say “social justice,” others would say “more revenue,” and at least one would say “simplification.” And that is the scary part, because private equity will lose out if reformers do not place the highest priority on growing the private sector when making tax decisions.
Let’s start with the Treasury Department proposals. In its annual tax recommendations to Congress, the Treasury Department once again proposed to prevent partnerships from treating carried interest as capital gains income. This change alone would severely damage the industry; especially lower and middle market investors, which depend on the carried interest model because they are paid for performance and cannot survive on management fees alone.
The Treasury Department also proposed hiking capital gains rates to 28 percent from its current top rate of 23.8 percent. I guess the economists were missing in action when this idea was floated around because history shows that hiking capital gains rates actually reduces capital gains revenues. During the four-year period before the Tax Reform Act of 1986 was enacted (Tax Years 1983-1986), when the top capital gains rate was 20 percent, the Treasury brought in an average of $11.7 billion in capital gains tax revenues. Conversely, during the four-year period after the Tax Reform Act of 1986 (Tax Years 1987-1990), when the top capital gains rate bounced as high as 28 percent, the Treasury only brought in an average of $8.1 billion in capital gains tax revenues. It seems pretty clear looking at that data that taxing capital gains at a higher rate is a deterrent to long term investing.
Let’s move now to the cornucopia of misguided ideas developed by some members of Congress. We are about two years removed from dramatic changes drafted by former Ways and Means Chairman Dave Camp. One of the more damaging ideas that would have struck the industry the hardest is the changes to subchapter K (partnerships) of the tax code. For starters, these changes would have required mandatory entity level partnership withholding. We warned that withholding could cause major disruptions for operating a private equity partnership, especially due to the fact that the flow of income changes so frequently in private equity funds from buying and selling companies. We won that argument and the idea was shelved, for now.
The partnership structure is one of the few beauties of the tax code because it encourages investors to pool capital into partnership entities and to deploy that capital fast and smoothly into portfolio companies. If Congress limits the current flexibility of partnerships to form and pass capital to and from portfolio companies, this would damage private equity’s ability to form effective capital deploying structures.
Yet another challenge to the industry is at the portfolio company level. Senators Marco Rubio (R-FL) and Mike Lee (R-UT) recently proposed a massive overhaul that eliminates the ability of companies to deduct interest on business debt. Not being able to deduct interest payments would be debilitating to your portfolio companies and to the industry. While a wholesale revamp of the tax code is not a near term reality, the Rubio-Lee plan should not be taken lightly, especially because one of the authors is a 2016 presidential candidate.
While you are reading this, tax writers in the Senate are holding backroom sessions to think about ideas to “reform” the tax code. If policymakers only view of private equity is from reading news stories about massive payouts to a few of the biggest partners at the biggest funds, then their ideas of reform and yours will be very different. Middle market private equity funds must engage now so that it does not fall victim to bad tax policy in the future.
Chris Walters is senior director of government affairs at the Small Business Investor Alliance, a trade organization representing lower mid-market private equity funds.