An Upcoming Debate on Whether Private Equity Should Pay Higher Taxes

By :: September 24th, 2013

If you are looking for a break from the dreary debate over the budget, our friends at Tax Analysts will be holding a roundtable discussion on Friday afternoon on the tax treatment of private equity firms. The issue has generated lots of interest since the First Circuit Court of Appeals ruled that a private equity firm was engaged in a “trade or business” under ERISA, the federal pension law.

If the court’s decision is extended to tax law, these firms and their investors could face significantly higher taxes than they do today. . 

My Tax Policy Center colleague Steve Rosenthal has argued the ruling, in a case called Sun Capital Partners v. New England Teamsters & Trucking, could result in a private equity fund being treated as an operating business rather than a passive investor. If Steve is right, returns to the firm’s managers could be taxed as ordinary income, rather than at lower capital gains rates. In addition, tax-exempt and foreign investors could be subject to U.S. tax on their returns. Steve has urged Treasury to write regulations to clarify these rules.

Interestingly, while Congress continues to debate whether the compensation of private equity managers, aka carried interest, should be taxed at higher rates, the reasoning in this case could open the door for higher taxes under current law, without the need for new legislation.

A key question:  Do private equity firms such as Sun Capital merely act as investors or do they manage the businesses they acquire in order to boost their profits. The firms make the legal argument that they only invest, but their promotional materials often claim that they aggressively intervene in the management of underperforming  companies before flipping them at a profit.   

Who’s right? Tax Analysts has arranged a roundtable to debate the issue. Besides Steve, participants will include Patrick B. Fenn, a partner at Akin Gump; John C. Hart, a partner at Simpson Thatcher & Bartlett, Harvard Law professor Steve Shay, and Tax Analysts contributing editor Lee Sheppard. Tax Analysts publisher Chris Bergin will moderate.    

The roundtable will be held at the National Press Club in Washington from 3-5 PM. It should be interesting.

3Comments

  1. Rich  ::  6:09 pm on September 24th, 2013:

    I’m not sure the ERISA case makes a difference. The ERISA case tells us that the attribution rules of 414(c) allow you to reach a private equity manager that has a substantial interest in a private equity fund that owns an operating business/employer–and then use agency law principles to reach the fund (partnership) through its general partner (manager). I’m not sure that agency principles would work for tax, especially since the corporations owned by a PE fund would be subject to tax on their operational results (though interest deduction prevents this from being worth mentioning).

    I also think manager compensation wouldn’t change. The “20” is a profits interest at the time the service provider receives it. Under Notice 2005-43 and related guidance, if the service provider partner makes an 83(b) election, he/she/it has a low/0-basis interest in the managed fund. That interest will be capital gain/loss property at disposition, the compensatory aspect having been completed. The fund will make money by selling operating businesses at a gain and distributing the proceeds if not reinvested. I think changing comp for investment partnership managers would require changing or eliminating the 83(b) election on “profits interests” or allocating gain-on-sale between “active” intervention in management and “passive” provision of capital. The former is probably more sensible.

  2. Michael Bindner  ::  10:42 pm on September 24th, 2013:

    In a VAT or Net Business Receipts Tax regime these firms would pay taxes on their revenue – both on the underlying operations and any sales generated by the vulture capitalism these firms are known for.

  3. Ralph H  ::  6:29 pm on September 25th, 2013:

    Of course they should. Of course the law often differs from what is right.

    When they sell they are entitled to the applicable capital gains rate.