Why the IRS Should be Taxing the Profits of Private Equity Funds as Ordinary Income

By :: February 4th, 2013

For years, the battle over carried interest has focused on how to tax the compensation of private equity managers. But a careful reading of  the law suggests that all the business profits of these investment firms, not just the pay of their managers, are ordinary income, and should be taxed that way.

Until now, the analysis of this issue has simply accepted the funds’ profits as capital gains. But when researching a newly-published article, “Taxing Private Equity Funds as Corporate Developers," I discovered that Congress intended capital gains to be defined narrowly so that ordinary profits—those that arise from the everyday operation of a business—would be taxed at regular rates.

Private equity funds earn sizable profits, largely from acquiring companies, improving them, and reselling them (and they now manage much greater amounts of money:  $2.5 trillion in 2010, up from $100 billion in 1994). The funds report these profits as capital gains, and allocate a large share to their managers as reward for their services (which is how Mitt Romney achieved 14% effective tax rates).  But what if these profits are not capital gains at all?  And what if our tax rules have been incorrectly subsidizing the growth of these funds for the last two decades?

Our tax laws generally treat the profits of taxpayers that develop and sell property in the course of a trade or business as ordinary income. For example, real estate developers often take many years to buy, develop and resell property, and they report their profits as ordinary income. So, why should private equity funds that buy, develop and resell companies (or their stock) treat their profits as capital gains?

Some believe that all gains from stock sales are capital. But that is not true: Equity that is held, for example, by a dealer (like a stock exchange floor specialist) is ordinary income. And private equity funds, like dealers, make a profit as middlemen: They both buy stock expecting to resell it at a higher price as remuneration for their intermediation efforts.

Although the public has expressed widespread astonishment at the low tax rates on the income of private equity fund managers, our lawmakers are frozen in response. Six years ago, Congressman Sander Levin (D-MI) first introduced legislation to treat any gains allocated to private equity managers as ordinary income. But his legislation stalled.  Instead, Congress has struggled to separate (and tax) only the labor, and not the capital, component of the private equity managers’ returns.  But these distinctions are overly complex and the latest versions of carried interest legislation are riddled with exclusions for “enterprise value” and other novel concepts.

But the biggest flaw of this approach is that it misses the point:  Business profits should be taxed as ordinary income. And private equity funds are the same as other businesses, in that they deploy capital, labor, and other inputs to make their profits.

The IRS should now focus squarely on all of the business profits of private equity funds, and not just the profits allocated to the managers. And it can write regulations to treat the profits as ordinary income without waiting for Congress to act.

13Comments

  1. Michael Bindner  ::  6:21 pm on February 4th, 2013:

    This would be radical and a breath of fresh air. I would expect that if they did this there would be an outcry and a movement to quickly legislate it away. It might also be the straw that breaks the camels back in corporate income tax reform and the inauguration of consumption taxes to replace them.

  2. Vivian Darkbloom  ::  5:26 am on February 5th, 2013:

    Interesting article. It’s refreshing to hear that in interpreting legislation the intent of Congress is relevant (unlike earlier views expressed here with respect to the platinum coin fraud).

    There are, however, some rough spots in the argument that the law, as intended by Congress, should treat gains (and losses) derived by private equity partnerships as “ordinary” because those funds are engaged in the business of “developing property” for sale “to customers”.

    It is nearly black letter law that the character of income, be it ordinary or capital, is determined at the partnership level and not at the partner level (see Section 702(a), etc). As Rosenthal correctly points out, the activities of a general partner are attributed to the partnership (and also to the limited partners) for this and other purposes . This attribution is relevant to determining whether a partnership (and therefore its limited partners) are engaged in a trade or business” and thus whether partnership income is “ordinary” under the following language:

    “property held primarily for the sale to customers in the ordinary course of a trade or business”.

    The above test contains two elements: 1) the partnership must be engaged in a trade or business; and 2) the property that has been sold must have been held for sale to customers.

    Rosenthal, while he mentions the issue of upward and downward attribution to and from a partnership, glosses over the fact that if the general partner satisfies the above-mentioned two tests, the partnership and its limited partners would, too. That means that with respect to gains derived by a private equity partnership, this interpretation would have much more far-reaching implications. It would mean, contrary to prior precedent, that not only would general partners be subject to ordinary income treatment on these stock sales, but so also would foreign investors (who would be deemed to have “income effectively connected with a US trade or business”).

    The real issue is indeed that Congressional intent is being ignored in the tax treatment of private equity partners. But, it is not the narrow issue Rosenthal has identified. The abuse is not of the capital gains tax rules per se, but of the partnership rules that determine how income is allocated among partners in a partnership. The abuse is rather of the rules regarding tax exempt status combined with these partnership income allocation rules. Persons not subject to US tax who are limited partners in these partnerships are engaging in tax arbitrage with the general partners. Because these limited partners (such as tax-exempt endowment funds) are not subject to US tax in any event, they are exchanging a share of their capital gain income (properly classified as such at the partnership level) to the taxable general partner for the general partner’s ordinary income (each as determined, prior to the exchange, by the respective contributions to partnership capital). In essence, these tax-exempt limited partners are improperly “selling” a portion of their tax-exempt status. *That* is the real abuse.

    And, only by properly identifying the problem will the solution be appropriate. The ”problem” of tax arbitrage in private equity partnerships could better be solved by changing the partnership allocation rules to prohibit tax exempt persons (perhaps as defined by the earnings stripping rules of section 163(j) ) from sharing that status with other taxable partners in a partnership. This solution would also avoid the more difficult and esoteric factual issues of whether someone is engaged in a “trade or business” or whether property is held for sale “to customers”.

    Unless this real cause of the problem is addressed, the solution will only be partial (the abuse of tax arbitrage with tax exempts exists in other partnership contexts and not just private equity) and properly targeting the abuse would not result in other consequences also not foreseen by Congress (taxing foreign investors and taxing US taxable

  3. Tax Roundup, 2/5/2013: Iowa conformity bill clears Senate. Also: the uses of GPS navigation! « Roth & Company, P.C  ::  9:00 am on February 5th, 2013:

    […] partnership tax isn’t screwed up enough?    Why the IRS Should be Taxing the Profits of Private Equity Funds as Ordinary Income (Steven Rosenthal, […]

  4. Vivian Darkbloom  ::  3:00 pm on February 5th, 2013:

    the last sentence was meant to conclude ( “and taxing US taxable persons investing as limited partners in investment partnerships at ordinary rates on what are now treated as long-term capital gains and losses).

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  6. Dave  ::  2:30 pm on July 31st, 2013:

    I don’t think that I agree with Mr. Rosenthal’s point about real estate, because large numbers of real estate partnerships use a similar GP-LP structure with carried interest for the GP and capital gains treatment.

  7. From the Bench: Sun Capital and its Potential Effects on the Private Equity Industry | Berkeley Business Law Journal  ::  7:16 pm on October 31st, 2013:

    […] the other hand, some com­men­ta­tors argue that the prof­its made by pri­vate equity firms come from their active […]

  8. Court of Appeals Finds a Trade or Business: Could this Mean Higher Taxes for Private Equity? | electronics-trade Products articles blog  ::  4:54 am on December 21st, 2013:

    […] While the decision in Sun Capital means that private equity funds may be liable for unfunded pension liabilities of their portfolio companies, it potentially has much broader tax implications that are critical for private equity funds and their investors.  For tax exempt or foreign investors, income from a private equity fund that is engaged in a trade or business is potentially subject to the unrelated business income tax (UBIT) or withholding taxes, respectively.  Moreover the decision buttresses the argument that the income of private equity managers should be taxed at higher ordinary income rates, rather than capital gains rates.  For more detail on this argument take a look at Tax Vox blogs here  and here. […]

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