Taxing Carried Interest and the Sale of Private Equity Firms

By :: June 10th, 2010

Critics of the ongoing congressional effort to tax compensation of private equity managers as high-rate ordinary income rather than low-rate capital gains are focusing on a new objection: Whatever the tax treatment of this so-called “carried interest,” Congress would unfairly raise taxes on the sale of these partnerships by also treating a share of the returns as ordinary income rather than capital gains.

This, say the critics, is an unprecedented effort to turn what are clearly gains—profits from the sale of a business—into ordinary income. It is, warn some, the first step towards eventually eliminating favorable capital gains treatment for all such transactions. Be afraid, they warn. Be very afraid.

But matters are a lot more complicated than they first appear. Those who would raise taxes on carried interest argue that for decades a handful of private equity firms have enjoyed special tax treatment not even afforded other partnerships. The carried interest bill, they say, does nothing more than level the playing field in two ways. First, it would treat these investment firms just like other partnerships. Second, it helps to equalize the tax treatment between private equity firms, hedge funds, and real estate partnerships on one hand and banks on the other. While they serve a similar capital-raising function, banks are corporations that get none of the favorable tax treatment enjoyed by their competitors that are organized as partnerships (of course, banks do get other benefits, such as deposit insurance, but that is another story).

University of Colorado law school professor Vic Fleischer, a long-time proponent of raising taxes on “the carry,” puts it this way: “The carried interest bill will require publicly-traded private equity firms to be taxed like corporations, just like other publicly-traded operating companies.”

To sort out who is right, let’s take a look at the bills and at the long history of all of this.

First, the House-passed version of the carried interest bill would treat 25 percent of the sale of a firm as a capital gain, and 75 percent as ordinary income. The 25 percent taxed as a gain represents a proxy for the portion of sale proceeds that represent goodwill (such as the firm's reputation). This rough justice solution, however, will inevitably create winners and losers. Hence, the controversy. The version proposed by the Senate Democratic leadership is more generous. It would treat 35 percent as capital gains, and would exempt energy partnerships from any tax increase. 

Supporters of the tax increase say it is important to apply the same formula to both a manager's compensation and the sale of his partnership interest. Without this backstop, carried interest held by the partnership would likely be  classified as goodwill and taxed at a low capital gains rate rather than the blended rate created by the bill.    

The history of all this goes back decades. In 1987, Congress worried that businesses would shift to partnership form to avoid the double tax paid by corporations. So it passed a law taxing publicly-traded partnerships as if they were corporations. But it grandfathered existing partnerships and carved out exemptions for others. In 2007, in what became known as the Blackstone bill, Congress moved to deny some tax benefits from the sale of investment partnerships such as the Blackstone Group. But that law also ended up protecting many publicly traded partnerships from the new strictures (even Blackstone itself was able to maximize its tax benefits after slightly restructuring the deal). 

It is hard to justify treating publicly-traded partnerships more generously than corporations, as Congress recognized 23 years ago. The best solution might be to lower the corporate tax rate and apply the levy to all publicly-traded partnerships. Such a step might avoid some of the clumsiness of the carried interest proposal.

Private equity firms and hedge funds may serve an important role in helping businesses grow, and where they do, their dealmakers deserve to be well compensated. But if they are as efficient at raising capital as they say, I don’t see why these firms (or their management) deserve special tax benefits for doing their jobs.