The IRS is listening

There’s been a lot of talk recently about the tax treatment of private equity in the US. Mitt Romney’s run for president in 2012 made the capital gains designation of carried interest a national talking point – and it continues to be a political football in Congress.

But what really got industry commentators and tax pundits talking was a July federal court ruling that certain Sun Capital funds were a “trade or business” for the purposes of the Employee Retirement Income Security Act; this triggered concerns that buyout firms with substantial operational involvement in a portfolio company could be liable for its unfunded pension liabilities. Although the court stressed that its ruling was limited to the applicability of ERISA, it led many to wonder whether the Internal Revenue Service (IRS) would be taking note of the court’s analysis.

What PE Manager has exclusively learned is that the IRS is indeed keenly aware of the case; in fact, it has even assembled a private equity taskforce to review the tax implications.

The ramifications of this could be huge. If the IRS starts designating private equity funds as a trade or business, carry could be taxed as ordinary income (at a rate of up to 39.6 percent) instead of as a capital gain (20 percent); foreign investors might have what is called effectively connected income (ECI), which would subject them to US tax; and tax-exempt LPs’ gains from the fund could be treated as “unrelated business taxable income” (or UBTI), which would also be subject to a 39.6 percent tax rate.

However, it seems unlikely that the IRS will take this approach. For one, the federal government is always hesitant about any change that might discourage foreign investment. If investing in a US buyout fund opens up even the slightest risk of foreign investors having to pay US tax, they may very well decide to park their cash elsewhere.

More importantly though, multiple industry tax lawyers we’ve spoken to seem confident that any analysis of US tax law supports the conclusion that traditional private equity funds serve as investment vehicles, and are not entities engaged in a trade or business. They generally cite two Supreme Court cases – Higgins (1941) and Whipple (1963) – to support their positions. So any major private equity tax reforms would have to be a legislative action, which seems unlikely at the moment.

It may be months or even years before the IRS private equity taskforce delivers any specific recommendations or guidance. But it’s worth highlighting now that the IRS is not only aware of the current tax debates around private equity, but also actively looking for solutions. For that reason alone, the industry needs to make sure it gets its point across loud and clear in the coming months.