The impending 2012 election has put tax law at the very center of the national conversation, but not all of the talk has been strictly about whether the rich should be paying more taxes. It has also focused on more esoteric issues like the so-called carried interest loophole that allows many hedge fund and private equity managers to pay a lower tax rate on fees they earn for running their investment funds.
One of the main reasons the issue has gotten so much attention, of course, is that Mitt Romney himself has benefitted from the carried interest tax rule, saving upwards of $2.5 million in taxes in 2010 and 2011, according to PolitiFact.com. But the carried interest rule is back in the headlines this week with recent reports in the New York Times and Wall Street Journal that New York Attorney General Eric Schneiderman has subpoenaed more than a dozen of the nation’s largest private equity firms — including Mitt Romney’s former employer Bain Capital — in an effort to investigate the industry’s possible use of the carried interest rule to evade New York State taxes.
The carried interest tax rule is made possible by the fact that tax rates for capital gains — money earned when an asset you own appreciates in value — is lower that that for money you earn through ordinary income. The top tax rate for ordinary income is 35%, while the top rate for capital gains is 15%.
Private equity fund managers — virtually all of whom are in the highest tax bracket — typically earn two types of income. The first is a management fee, usually around 2% of total assets managed. The second is a performance fee, commonly set at 20% of the return of the fund. So, if a fund has $10 million under management and appreciates by 20% in a given year, a manager will make $200,000 in management fees and $400,000 in performance fees. In many cases, the management fees will be taxed as ordinary income, because these are fees charged for the everyday administration of the fund, regardless of how well the fund performs. The performance fee, however, is treated as a capital gain, because fund managers are considered part owners of the funds they administer even if they are risking little or none of their own capital.
This tax treatment is controversial, but generally considered legal by tax experts and federal and state authorities. The issue that Schniederman is now investigating, however, is the slightly different practice of fund managers foregoing their management fees and funneling them into their funds so that they’ll too be taxed at the much-lower capital gains rate. Victor Fleischer, a University of Colorado Law Professor and frequent critic of the carried interest rule, described the practice in a recent blog post:
“Each year, before the annual management fee comes due, the fund manager waives the management fee in exchange for a priority allocation of future profits. There is minimal economic risk involved; as long as the fund, at some point, has a profitable quarter, the managers get paid. (If the managers don’t foresee any future profits, they won’t waive the fees, and they will take cash instead.) In exchange for a minimal amount of economic risk, the tax benefit is enormous: the compensation is transformed from ordinary income (taxed at 35%) into capital gain (taxed at 15%). Because the management fees for a large private equity fund can be ten or twenty million per year, the tax dodge can literally save millions in taxes every year.
The problem is that it is not legal. Because the deals vary in their aggressiveness, there is some disagreement among practitioners about when it works and when it doesn’t. But in my opinion, and the opinion of many tax practitioners, the practices that were common in the private equity industry in the 2000s became very, very questionable, and it’s unlikely that they would have stood up in court.”
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It isn’t yet clear what the Attorney General will uncover in his investigation, but the tax implications for New York State aren’t nearly as large as they would be for the federal government. There aren’t seperate tax rates for capital gains and ordinary income; the only benefits of using this strategy in terms of New York State income taxes would be to delay paying taxes until the capital gain is realized. But the New York Attorney General does not have the ability to go after private equity firms for breaking federal tax laws — although if an investigation uncovers any sort of wrong-doing it could put pressure on the IRS to conduct its own inquiry.
In fact, unnamed sources in the New York Times report have accused Scheidernman of political motivations. “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,” the report said. And if the Attorney General were to find evidence of tax evasion at Bain Capital, it would be hard to see how it wouldn’t hurt Romney’s political chances given his extensive experience at the firm and the fact that he has, himself, benefitted from the carried interest rule.
In any case, one wonders why, if this sort of behavior has “been common practice since the 2000s” as Fleischer alleges, that it hasn’t been investigated by federal or state officials before now. It’s one thing to debate the wisdom of lower tax rates for carried interest or capital gains, its another thing entirely to tolerate outright tax evasion.