Academic: GPs can offset higher carry taxes(3)

University of Pennsylvania Law School professor Michael Knoll has concluded that even if carry is taxed as ordinary income, GPs will be able to restructure their funds to counterbalance higher tax bills.

Taxing private equity general partners’ carried interest as ordinary income would result in up to $3 billion (€2.2 billion) of additional annual tax revenue – but funds will be able to alter their terms so as to offset any additional taxes, according to University of Pennsylvania Law School professor Michael Knoll.

Congress is currently mulling a bill that proposes taxing carry as ordinary income, which equates to a rate of as high as 35 percent, as opposed to its current capital gains rate of 15 percent.

Should the bill pass into law, the simplest solution would be to have limited partners make additional, tax-deductible payments that cover the general partners’ additional tax, Knoll says in his recently released paper, “The Taxation of Carried Interests: Estimating the Revenue Effects of Taxing Profit Interests as Ordinary Income”.

“For example,” he wrote, “if the carry were taxed at 35 percent when realised, then increasing the carry from 20 percent to 30.8 percent would leave the economic arrangement unchanged for limited partners who were wealthy US individuals.”

Knoll argued that funds could also be restructured so that portfolio companies pay carry instead of limited partners, which would likely translate to a tax deductible business expense that offsets additional taxes on the GP’s carry.

This sort of structural change – which would mean carry is measured on a company-by-company basis versus an aggregate basis – might not please LPs, noted Victor Fleischer in a posting on business, law and economics blog Conglomerate.

Fleischer, a University of Colorado professor who has published a paper in favour of increasing the tax on carry, also noted that because of the levels of debt many portfolio companies take on, it is unclear how many would actually have the high effective tax rate necessary to gain the tax deductions outlined by Knoll.

According to a footnote in Knoll’s paper, if the tax on carry increases and fund structures do not change, “it is likely that the composition of the limited partners will change and private equity funds will raise less capital”.

Similar arguments were recently made before the Senate Finance Committee by Carlyle Group partner Bruce Rosenblum, who also chairs the Private Equity Council. Rosenblum said a change in policy would create unintended consequences including diminished incentives for new fund formation and altered investment structures.