Strasburger Tax Strategies Newsletter

The recent Blackstone Group IPO has prompted a flurry of media reports and political commentary complaining that private equity managers are exploiting tax loopholes and pay too little tax. As frequently happens when news reporters and politicians react to complicated tax issues, misinformation abounds. This newsletter examines three aspects of private equity taxation that are highlighted by the Blackstone IPO and have drawn the most fire from critics: carried interests, publicly traded partnership status, and goodwill amortization.

Carried Interests

A fund manager typically receives a fixed annual management fee (e.g., 2% of the assets under management) and a performance allocation or “carried interest” representing a share of the any net profits of the fund (e.g., 20% of net profits). The management fee is treated as compensation income subject to ordinary income taxes (up to 35%) and self-employment taxes (2.9% on amounts over $97,500). The carried interest is treated as an ownership interest in the partnership and is taxed according to the nature of the profits the fund earns. If the fund earns ordinary income (interest) or short-term capital gains, the manager pays tax on its share of that income at a 35% tax rate. If the fund earns long-term capital gains or qualified dividend income, the manager pays tax on its share of that income at a 15% tax rate. Because Blackstone tends to buy equity interests in portfolio companies and hold the equity for long-term appreciation, the Blackstone funds tend to produce mostly long-term capital gains.

Critics argue that a carried interest is nothing more than compensation income for the investment management services provided by the fund manager. In a July 12 New York Times op-ed piece, Paul Krugman characterized a carried interest as no different that the tips a waitress earns or the commissions a salesman earns. He argues that fund managers aren’t like “an entrepreneur who sinks his life savings into a new business” because fund managers “aren’t putting their own assets on the line.” These sentiments are shared by many who argue for taxing income from a carried interest as compensation income.

The argument that a carried interest is equivalent to tips or commissions overlooks the fact that tips, commissions, and other similar types of performance based compensation are not directly contingent on the long-term success of the underlying business. In contrast, a carried interest is an ownership interest in the business and has value only if the business is successful over the long term.

Critics also wrongly imply that entrepreneurs recognize capital gains only because they invest their life savings in the business. In reality, whether or not an entrepreneur invests any money in a venture, and how much money he or she invests, is irrelevant to the tax treatment of his or her compensation. Only the form of the compensation is relevant. If the entrepreneur chooses to be paid a salary and bonus, the compensation is ordinary income. If the entrepreneur chooses to take stock in the company, any gain in the value of the stock is capital gain. It’s essentially the same for a fund manager. If the fund manager chooses to receive fixed management fees, the fees are compensation income. If the manager chooses to receive an interest in the fund’s future profits, those profits are taxed according to their character. The profits might be qualified dividend income or long-term capital gain eligible for the 15% capital gains tax rate, or the profits might be ordinary income or short-term capital gain taxed at the 35% tax rate on ordinary income.

It is equally wrong to say that fund managers don’t have any assets on the line. Fund managers commonly have a significant financial investment in their businesses, because they sincerely believe in their ability to grow the value of their investment and because investors feel better knowing that the manager has some “skin in the game.” More importantly, fund managers, like other entrepreneurs, contribute their services (sweat equity) and intellectual capital (business and investment strategies, industry insights, financing strategies, etc.) to the business. All these forms of investment – money, services, and intellectual capital – create long-term value, and each is entitled to capital gains treatment under current law.

Those who attack the tax treatment of carried interests imply that only value created by financial capital is worthy of the lower tax rates for capital gains. The logic of this argument is difficult to discern, and trying to distinguish between value created by financial capital and value created by other forms of investment is much more complicated than it might seem. One wonders whether the critics’ real agenda is to repeal capital gains tax rates for all forms of investment.

Publicly Traded Partnership Status

Most private equity funds are organized as partnerships. A partnership’s income generally flows through to its partners and is taxed only once. In contrast, a corporation’s income is taxed twice: once to the corporation and again to its shareholders. Special rules apply to publicly traded partnerships (PTPs). Most PTPs are treated as corporations for tax purposes and pay double tax. The theory is that partnerships that choose to access the public equity markets are operating like publicly traded corporations and should be double taxed like corporations so that the corporate tax base is preserved. When the special rules for PTPs were enacted in 1987, an exception was created for entities earning passive type income, such as interest, dividends, and capital gains. Blackstone Group qualifies for this exception. So even though Blackstone is now a publicly traded entity, it qualifies to be taxed as a partnership.

Critics argue that Blackstone is essentially a corporate holding company actively managing a portfolio of subsidiaries and should be taxed like any other publicly traded corporation. Warren Buffet complains that it is unfair that his investment company (Berkshire Hathaway) is subject to corporate tax while Blackstone is not. This argument raises fundamental questions about whether all partnerships (public and private) should be taxed as corporations and whether corporate double taxation is good tax policy. Changing the PTP rules is unlikely to resolve these fundamental issues or reverse the erosion of the corporate tax base. Private equity can simply remain private, or can choose other tax efficient structures to access the public equity markets. Moreover, there is no compelling evidence that Congress’s decision in 1987 to exempt investment partnerships from corporate tax was wrong and needs to be changed.

Goodwill Amortization

When a fund manager or entrepreneur builds up the value of a business, that value is often reflected in an intangible asset called goodwill. Goodwill represents the capacity of the business to earn above market returns in the future. When the business is sold, the seller recognizes capital gain on the goodwill. The buyer amortizes the purchase price for goodwill over 15 years, offsetting tax on future earnings that represent a recovery of the goodwill investment rather than true income. Goodwill amortization ensures that goodwill is taxed only once.

The Blackstone IPO triggered goodwill gain. Blackstone apparently decided that investors would not ascribe full value in the IPO to the resulting goodwill amortization. (IPO shares are often valued based on pre-tax measures.) So Blackstone established a “tax receivable agreement” that allocates 85% of the goodwill amortization benefit to Blackstone’s managers. This arrangement is not uncommon and is not unique to the private equity industry.

Critics argue that the effect of the tax receivable agreement gives the Blackstone managers a windfall at the government’s expense. A July 13 New York Times article states: “Although they will initially pay $553 million in taxes, the partners will get that back, and about $200 million more, from the government over the long term.” (Emphasis added.)

This is a gross mischaracterization. The government isn’t paying Blackstone or its managers anything: all the taxes that are due will be paid, and none will be refunded. The tax receivable agreement regulates the sharing of settled tax benefits between Blackstone’s managers and investors. The government has no stake in this private contractual arrangement, and critics have no standing to question its legitimacy.

Conclusion

Highly sophisticated investors voluntarily agree to generous compensation arrangements for private equity managers because the investors believe the managers have unique skills and investment insights that can deliver extraordinary returns. Private equity managers have legitimately structured these compensation arrangements to benefit from well defined tax incentives for long term risk based investments. Policy makers should think carefully before tampering with these incentives. In trying to skewer a few highly successful fund managers, Congress could stifle the entrepreneurship that drives our economy.

Editor’s Note: To view Jim’s appearance on CNBC’s Morning Call arguing against raising taxes on private equity income, Click Here or visit the News and Media section of our website (www.strasburger.com).