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Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Sunday, September 2, 2012

NY Times: NY AG Investigates Tax Treatment of Bain Capital Management Fees

New York Times:  Inquiry on Tax Strategy Adds to Scrutiny of Finance Firms:

The New York attorney general is investigating whether some of the nation’s biggest private equity firms have abused a tax strategy in order to slice hundreds of millions of dollars from their tax bills, according to executives with direct knowledge of the inquiry.

The attorney general, Eric T. Schneiderman, has in recent weeks subpoenaed more than a dozen firms seeking documents that would reveal whether they converted certain management fees collected from their investors into fund investments, which are taxed at a far lower rate than ordinary income. ...

Some executives at the firms said they feared that Mr. Schneiderman, a first-term Democrat with ties to the Obama administration, was seeking to embarrass the industry because of Mr. Romney’s roots at Bain. Others suggested that the subpoenas, which were issued by the attorney general’s Taxpayer Protection Bureau, might be part of an effort to recover more revenue for New York under state tax law. The attorney general’s office does not have the power to enforce federal tax laws. ...

The tax strategy — which is viewed as perfectly legal by some tax experts, aggressive by others and potentially illegal by some — came to light last month when hundreds of pages of Bain’s internal financial documents were made available online. The financial statements show that at least $1 billion in accumulated fees that otherwise would have been taxed as ordinary income for Bain executives had been converted into investments producing capital gains, which are subject to a federal tax of 15%, versus a top rate of 35% for ordinary income. That means the Bain partners saved more than $200 million in federal income taxes and more than $20 million in Medicare taxes. ...

The tax strategy used by Bain and other firms to convert management fees — the compensation normally taxed as ordinary income — into capital gains is known as a “management fee waiver.” The strategy is widely used within the industry: 40% of the 35 buyout firms based in the United States surveyed in 2009 by Dow Jones said their partners used at least some of the firm’s fees to make investments in their funds. But some prominent firms appear to avoid the practice. The Carlyle Group and Blackstone Group have stated in regulatory filings that their partners have not diverted management fees into investments in their funds....

Tax lawyers have justified the arrangements by arguing that converting the management fees into carried interest, which could lose some or all of its value if a fund does poorly, entitles the managers to the lower capital gains rate, which is intended to help mitigate the risks taken by investors. "They’re risking their management fee -- they’re giving up the right to that management fee in any and all events,” said Jack S. Levin, a finance lawyer whose firm has represented Bain on some matters. Mr. Levin said he did not consider the practice risky or even aggressive. “The IRS has known that private equity funds have been doing this for 20 years,” he said.

In 2007, the agency began taking a closer look at suspected tax abuses at hedge funds and private equity firms. In a statement at the time, an IRS spokesman said that management fee conversions were among several “areas of possible noncompliance.” But no formal ruling appears to have emerged.

Some private equity firms take what tax experts consider a less aggressive approach to the conversions, waiving fees on all of a given fund’s investments over the lifetime of the fund, which can be 10 years. ...

Victor Fleischer, a law professor and finance expert at the University of Colorado who has been critical of the tax rules for private equity firms, said he believed Bain had waived management fees into investments with so little risk that the arrangement would not qualify for the capital gains rate if challenged by the IRS. “There is a tension between economic risk and tax risk that is supposed to be inversely proportional,” Mr. Fleischer said. “The way Bain set it up there’s not much risk at all, so it’s hard to see how this income should receive capital gains treatment.”

(Hat Tip: Ann Murphy.)


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Democrats convened in Charlotte, NC, will double down on their claim that Bain Capital is really the Bain crime family. They will accuse Republican nominee Mitt Romney and Bain’s other “greedy” co-founders of stealing their winnings, evading taxes and lighting cigars with $100 bills on their yachts.

But Bain’s private-equity executives have enriched dozens of organizations and millions of individuals in the Democratic base — including some who scream most loudly for President Obama’s re-election. ....

Posted by: Woody | Sep 2, 2012 10:23:53 AM

Can someone please tell us why the Attorney General of the state of New York is doing this? New York State does not differentiate between ordinary income and capital gains, so there is no net revenue impact here.

Presumably there is a timing issue, but is that it?

@ Woody:

Bain has enriched millions of individuals in the Democratic Base??? C'mon man, we're trying to be serious here.

Posted by: David R. | Sep 2, 2012 4:00:21 PM

@ David: the timing difference is certainly one difference. Another is whether the income is NY source. I think - although I'm not 100% positive - that management fee income is NY source income. A CT resident hedge fund manager that works in midtown pays income tax to NY for the management fee. By converting it to partnership interest, it becomes investment income that is only taxable by the resident state. That's a huge, huge, huge incentive for NY to investigate.

Posted by: jpe | Sep 4, 2012 7:28:13 AM