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A recent court case has given the federal government a chance to sidestep Congress and eliminate private equity's billion-dollar tax break. The question is whether the Obama administration takes up the fight.
At issue is "carried interest" — a term of art that refers to the profits that a private equity adviser makes from investing in companies. Because of what critics term a loophole and private equity firms call common sense, such income is taxed at the capital gains rate of 20 percent instead of as income, which would put it at a maximum of 39.6 percent. That tax treatment has meant that the heads of private equity firms like the Blackstone Group's Stephen A. Schwarzman pay billions of dollars less in taxes.
This apparent inequality has led many to protest. After all, why should these private equity barons, many of whom are extraordinarily wealthy, get to profit to the tune of extra billions? Even Mr. Schwarzman's co-founder at Blackstone, Peter G. Peterson, has come out against the tax break, stating he "can't justify that."
In defense, private equity advocates like the Private Equity Growth Capital Council argue that the profits are investment income and to change the tax code would mean that private equity firms would have less of an incentive to invest, upending a policy that "has helped America prosper for more than 100 years."
(Read more: Private Equity: CNBC Explains)
Unswayed, the Obama administration has tried repeatedly to tax private equity profits as income, a move that would raise an estimated $16 billion extra over a decade. The rabid anti-tax fervor in Congress, however, has prevented any change.
Now, a court case involving the private equity firm Sun Capital Partners has upended the entire treatment of carried interest.
Sun Capital, run by Marc J. Leder and Rodger R. Krouse, specializes in buying and selling distressed companies. The case arose out of its $7.8 million buyout in 2007 of Scott Brass, a manufacturer of high-quality brass and copper used in electronics and other products.
About a year after the takeover, Scott Brass sought bankruptcy protection. Sun Capital sued the company's pension fund, the New England Teamsters and Trucking Industry Pension Fund, seeking a judgment that it was not liable for $4.5 million of the company's pension.
Under the pension laws, Sun Capital would be responsible for this amount if Scott's employees were under the control of Sun and the funds were engaged in a "trade or business."
The pension fund argued that the Sun Capital funds were liable because the funds were engaged in the trade or business of operating Scott. Sun Capital argued the opposite, saying that it was merely a passive investor.
The Federal Court of Appeals for the First Circuit in Massachusetts sided with the pension fund, ruling this summer against the two Sun Capital funds involved in the buyout.
The court determined that the Sun Capital funds were arguably involved in a "trade or business" through their ownership of Scott because the funds were "actively involved in the management and operation of the companies in which they invest." The decision also went up the chain through the legal entities to hold the firm responsible.
(Read more: Private equity loses out to mega-IPOs)
What does this pension fund case have to do with carried interest?
Well, in order to take advantage of capital gains treatment for carried interest, private equity firms must also satisfy rules that they are not engaged in a "trade or business," operating the company they own. The phrasing in the tax code is similar to the statute at issue in the Sun Capital case.
The implication is that if Sun Capital is liable under the pension laws for simply doing what private equity funds do — manage companies — than the other provision of the tax laws allowing for carried interest is no longer met.
Sun Capital has hit like a bomb in the private equity industry, notes Victor Fleischer, professor of law at the University of San Diego and a DealBook contributor. Showing how serious tax experts take this, Tax Notes, the leading tax publication, ran a series of articles on the case and private equity in a recent issue.
(Read more: Private Equity Bracing for Higher Rates)
The Treasury Department and the Internal Revenue Service have a good argument that private equity firms should no longer be permitted to get carried interest treatment.
Craig Gerson, an adviser in the Treasury's Office of Tax Legislative Counsel, acknowledged this in a speech at the American Bar Association meeting on Sept. 20. According to Bloomberg News, he said that "there's a recognition that the court's decision may give us an opportunity to reassess what 'trade or business' means."
And as one article in Tax Notes argued, this was "common sense," not a matter of fairness or income inequality. Private equity firms are engaged in buying and managing companies. Taxing carried interest as income simply recognizes what we knew all along. This is the opening that the Obama administration has wanted. The battle over carried interest is now out of the arena where private equity had its best ally, Congress.
Yet, the Obama administration is not certain to take up its chance for victory. Mr. Gerson said that he did not think there would "be any rush to issue guidance on this."
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In part, this is because it would not be a simple win. The IRS would have to make the claim either through a new position or rules. Private equity firms would no doubt contest this, meaning litigation. And let's face it, the government has barely been open for business as of late, and is not up to fighting what would be a titanic battle with some of the richest people on the planet.
Another of those Tax Notes articles was more favorable to private equity's case, calling this decision limited to the "rip, strip and flip" type of private equity investing. It may be that the firms can reorganize their investments to be more passive and exclude management fees and other attributes that make them look like a trade or business.
(Read more: Why private equity loves 'FroYo')
There are two unusual twists here. First, it was a private equity firm that created this opening through its aggressive actions. Sun was trying to discard Scott's pension liabilities through the bankruptcy process, something it had previously been accused of in the bankruptcy of Friendly's Ice Cream. By trying to save a measly $4.5 million, Sun Capital may cost the industry billions.
Second, it may now be that this battle to tax carried interest is not won or lost in the halls of Congress over high-minded concepts of fairness or equity, but rather in the halls of the IRS by applying common sense presumptions that existed all along.
Washington, it's your move.
—By Steven M. Davidoff of The New York Times. Davidoff is a professor at the Michael E. Moritz College of Law at Ohio State University and the author of "Gods at War: Shotgun Takeovers, Government by Deal and the Private Equity Implosion. " E-mail: firstname.lastname@example.org | Twitter: @StevenDavidoff