GO
Loading...

Bobbing as the Taxman Weaves

To the long list of new financial regulations that were once considered improbable but now seem possible, add this one: a tax rule that would treat the investment gains of partners in hedge funds and private equity firms as ordinary income rather than as capital gains.

Just a tax technicality? Far from it.

General partners at private equity funds, who take a cut of the investment gains they earn for their investors in the form of “carried interest,” have been paying federal taxes worth only 15 percent of that cut.

By contrast, most people in the top tax bracket pay 35 percent on their income — soon to be 39.6 percent.

Sheet of US one hundred dollar bills
Don Farrall | Digital Vision | Getty Images
Sheet of US one hundred dollar bills

The change in the tax law could hand the government nearly $25 billion in new tax revenue over the next decade while making a lot of rich people a little less rich.

“I think you’re going to see a change in the taxation of carried interest pass the Senate within the next few weeks,” Peter R. Orszag, the White House budget director, said last week at a private breakfast sponsored by Reuters.

Of course, even if the measure passes, Wall Street executives are ready: They’ve already begun devising clever new “structures” to skirt the tax change.

The moment the bill is signed, “the games will begin,” said Francois Hechinger, a tax partner at BDO Seidman who advises venture capital firms. “That’s when people will try to figure out how to get around this.”

If we’ve learned anything from the financial crisis, it seems that new regulations on Wall Street always have a way of breeding another generation of “financial innovation” meant to circumvent them.

The debate over taxing the lords of private equity, of course, has been swirling since the height of the buyout boom in 2007. But the financial crisis and the economic carnage it created appeared to have derailed those efforts. Until now.

The House of Representatives, aware that some titans of finance were already charting a course around any proposed change to their tax status, included a special provision in its version of the new legislation levying a 40 percent penalty for executives who invoked a loophole to cut their tax bill but were later ruled to have been wrong in doing so.

Still, that hasn’t stopped them from trying.

One of the latest machinations being whispered about in the industry goes like this: Private equity executives would sell their “carried interest” to a third party and then use the cash they received to invest directly in the deal so that any increase in value would be a capital gain.

“We don’t know if it works or not,” Mr. Hechinger said.

Capital gains have long been taxed at a lower rate than ordinary income because investors risk their own money when they make their bets.

Under their current partnership structure, however, general partners — like executives at Kohlberg Kravis Roberts or TPG — receive 20 percent of any profits and they have been treating that as a capital gain even though their own money is not at risk. A lot of people, including me, have been arguing for years that their cut of the winnings is really income, not capital gains.

(Of course, profits that executives make by investing their own money in the deals should be considered capital gains.)

Another idea that has been bandied about would have investors in a fund make a loan to the general partner worth 20 percent of the deal, instead of sharing 20 percent of the profits. Again, the general partners would use the lent money to buy a 20 percent stake in the deal for themselves, thus making any upside a capital gain. That specific idea appears to have already been outlawed by language in the latest bill.

“Any time there is a new section of the tax code there are going to be lawyers who will try to manipulate the rules,” said Victor Fleischer, associate professor of law at the University of Colorado at Boulder. Mr. Fleisher wrote a paper on this topic in 2007 that was used by Congress as the basis for the new proposed change.

Mr. Fleischer said he was aware that some private equity firms, which manage money for wealthy individuals as well as pensions and endowments, had talked to their lawyers about moving certain funds offshore to take advantage of more favorable tax codes.

He said some firms were also discussing a drastic change: dismantling their partnership structure and making investments in companies on behalf of their investors on a deal-by-deal basis. That way, the general partners could get access to “founders’ shares” in the form of common stock, which would be subject only to capital gains tax.

“Institutional investors are not going to like any of these schemes,” Mr. Fleischer said, somewhat exasperated by the lengths the firms have gone to game the system. “I don’t think that Calpers would like to restructure the industry so that limited partners can pay lower taxes.”

Of course, not everyone is trying to get around the rules. Some who would get caught in the net aimed at private equity are trying instead to block them from being added to the bill in the first place. While the measure is intended to collect higher taxes from private equity players, it would affect all firms that use partnership accounting, including industries like venture capital and real estate funds.

Both of those industries in particular have been desperately seeking to be excluded, or “carved out” in Washington parlance. Venture capitalists have argued that they are the backbone of innovation in the United States, providing start-up capital to companies like Google and Apple.

Removing the tax break, they suggest, is tantamount to “discouraging investment in new companies at a time when Congress should be doing all it can to support the start-up ecosystem,” according to the National Venture Capital Association.

Their pitch has attracted some sympathy: four Democratic senators and one Republican, Scott Brown of Massachusetts, sent a letter to the Senator Max Baucus, chairman of the finance committee, and Senator Charles Grassley, the ranking Republican, seeking an exemption.

Real estate funds, similarly, are pressing for an exemption, arguing that property values are in such decline that the tax change would further stifle the industry and the prices they are willing to pay. Their position has the support of the Conference of Mayors.

Whether certain industries get excluded or not, Congress beware: Wall Street will find a loophole.