Paul L. Caron
Dean




Monday, June 14, 2021

NY Times: Private Inequity — How A Powerful Industry Conquered The Tax System

New York Times, Private Inequity: How a Powerful Industry Conquered the Tax System:

There were two weeks left in the Trump administration when the Treasury Department handed down a set of rules governing an obscure corner of the tax code.

Overseen by a senior Treasury official whose previous job involved helping the wealthy avoid taxes, the new regulations represented a major victory for private equity firms. They ensured that executives in the $4.5 trillion industry, whose leaders often measure their yearly pay in eight or nine figures, could avoid paying hundreds of millions in taxes.

The rules were approved on Jan. 5, the day before the riot at the U.S. Capitol. Hardly anyone noticed.

The Trump administration’s farewell gift to the buyout industry was part of a pattern that has spanned Republican and Democratic presidencies and Congresses: Private equity has conquered the American tax system. ...

While intensive examinations of large multinational companies are common, the I.R.S. rarely conducts detailed audits of private equity firms, according to current and former agency officials.

Such audits are “almost nonexistent,” said Michael Desmond, who stepped down this year as the I.R.S.’s chief counsel. The agency “just doesn’t have the resources and expertise.”

One reason they rarely face audits is that private equity firms have deployed vast webs of partnerships to collect their profits. Partnerships do not owe income taxes. Instead, they pass those obligations on to their partners, who can number in the thousands at a large private equity firm. That makes the structures notoriously complicated for auditors to untangle. ...

“If you’re a wealthy cheat in a partnership, your odds of getting audited are slightly higher than your odds of getting hit by a meteorite,” [said] Senator Ron Wyden. ...

The industry makes money in two main ways. Firms typically charge their investors a management fee of 2 percent of their assets. And they keep 20 percent of future profits that their investments generate.

That slice of future profits is known as “carried interest.” The term dates at least to the Renaissance. Italian ship captains were compensated in part with an interest in whatever profits were realized on the cargo they carried.

The I.R.S. has long allowed the industry to treat the money it makes from carried interests as capital gains, rather than as ordinary income.

For private equity, it is a lucrative distinction. The federal long-term capital gains tax rate is currently 20 percent. The top federal income tax rate is 37 percent.

The loophole is expensive. Victor Fleischer, a University of California, Irvine, law professor, expects it will cost the federal government $130 billion over the next decade.

Back in 2006, Mr. Fleischer published an influential article highlighting the inequity of the tax treatment. It prompted lawmakers from both parties to try to close the so-called carried interest loophole. The on-again, off-again campaign has continued ever since.

Whenever legislation gathers momentum, the private equity industry — joined by real estate, venture capital and other sectors that rely on partnerships — has pumped up campaign contributions and dispatched top executives to Capitol Hill. One bill after another has died, generally without a vote. ...

One day in 2011, Gregg Polsky, then a professor of tax law at the University of North Carolina, received an out-of-the-blue email. It was from a lawyer for a former private equity executive. The executive had filed a whistle-blower claim with the I.R.S. alleging that their old firm was using illegal tactics to avoid taxes.

The whistle-blower wanted Mr. Polsky’s advice.

Mr. Polsky had previously served as the I.R.S.’s “professor in residence,” and in that role he had developed an expertise in how private equity firms’ vast profits were taxed. Back in academia, he had published a research paper detailing a little-known but pervasive industry tax-dodging technique.

Private equity firms already enjoyed bargain-basement tax rates on their carried interest. Now, Mr. Polsky wrote, they had devised a way to get the same low rate applied to their 2 percent management fees. ...

“It’s like laundering your fees into capital gains,” said Mr. Polsky, whose paper argued that the I.R.S. could use longstanding provisions of the tax code to crack down on fee waivers. “They put magic words into a document to turn ordinary income into capital gains. They have zero economic substance, and they get away with it.” ...

The Times reviewed 10 years of annual reports filed by the five largest publicly traded private equity firms. They contained no trace of the firms ever having to pay the I.R.S. extra money, and they referred to only minor audits that they said were unlikely to affect their finances.

Current and former I.R.S. officials said in interviews that such audits generally involved issues like firms’ accounting for travel costs, rather than major reckonings over their taxable profits. The officials said they were unaware of any recent significant audits of private equity firms. ...

Kat Gregor, a tax lawyer at the law firm Ropes & Gray, said the I.R.S. had challenged fee waivers used by four of her clients, whom she wouldn’t identify. The auditors struck her as untrained in the thicket of tax laws governing partnerships.

“It’s the equivalent of picking someone who was used to conducting an interview in English and tell them to go do it in Spanish,” Ms. Gregor said.

The audits of her clients wrapped up in late 2019. None owed any money.

As a presidential candidate, Mr. Trump promised to “eliminate the carried interest deduction, well-known deduction, and other special-interest loopholes that have been so good for Wall Street investors, and for people like me, but unfair to American workers.”

But his administration, stocked with veterans of the private equity and hedge fund worlds, retreated from the issue.

In 2017, as Republicans rushed through a sweeping package of tax cuts, Democrats tried to insert language that would recoup some revenue by collecting more from private equity. They failed. ...

While White House officials claimed they wanted to close the loophole, congressional Republicans resisted. Instead, they embraced a much milder measure: requiring private equity officials to hold their investments for at least three years before reaping preferential tax treatment on their carried interests. Steven Mnuchin, the Treasury secretary, who had previously run an investment partnership, signed off. ...

It was a token gesture for an industry that, according to McKinsey, typically holds investments for more than five years. The measure, part of a $1.5 trillion package of tax cuts, was projected to generate $1 billion in revenue over a decade.

Private equity cheered. One of the industry’s top lobbyists credited Mr. Mnuchin, hailing him as “an all-star.”

Mr. Fleischer, who a decade earlier had raised alarms about carried interest, said the measure “was structured by industry to appear to do something while affecting as few as possible.” ...

It took the Treasury Department more than two years to propose rules spelling out the fine print of the 2017 law. ... On Jan. 5, the Treasury Department unveiled the final version of the regulations. Some of the toughest provisions had vanished. Among those was the one that would have allowed the I.R.S. to scrutinize transactions between different entities controlled by the same firm. The result was that it became much easier to maneuver around the three-year holding period.

“The government caved,” said Monte Jackel, a former I.R.S. attorney who worked on the original version of the proposed regulations.

Mr. Mnuchin, back in the private sector, is starting an investment fund that could benefit from his department’s weaker rules.

(Hat Tip: Steven Sholk, Bill Turnier)

https://taxprof.typepad.com/taxprof_blog/2021/06/ny-times-private-inequity-how-a-powerful-industry-conquered-the-tax-system.html

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