The private equity industry is once again engaged in an intellectual battle with critics of carried interest treated as a capital gain under the US tax code.
This time around the Private Equity Growth Capital Council (PEGCC) hopes that an educational video using accessible language, blue diagrams and images against a whiteboard will help turn the tide of public opinion in favor of the status quo.
The group’s defense of carry as a return on investments made by private equity partners is a rebuttal against those who argue it better represents a form of compensation for services rendered.
The video’s release coincides with discussions in Congress over how to plug deficit spending, preserve entitlement programmes, and potentially raise the nation’s $16.4 trillion debt ceiling limit. In an interview before Super Bowl Sunday, President Barack Obama signaled that Democrats would put carry on the negotiating table with Republicans, who have thus far blocked any tax hikes on fund managers’ share of fund profits. Under ordinary income tax rates, the government estimates some $13 billion in revenue could be raised over the next 10 years.
But taxing carry under ordinary income rates (which stand at 39.6 percent for top earners) would defy 100 years of established tax practices, the PEGCC argues in its video.
“The rationale is based on the uniquely American principle of rewarding those who take entrepreneurial risk. Whether that risk involves investing capital, or operational expertise, or in the case of private equity, both,” says the video’s narrator.
Critics contend that because private equity partners do not purchase their partnership share – excluding their own personal commitments or “skin in the game”– that the GPs’ share of the profits is in reality a form of deferred compensation for their due diligence, investment and portfolio monitoring services of the fund.
I provide my sweat equity to my law firm’s business and I take risk and still all of the income I receive is ordinary income
The video counters those services are actually a form of “sweat equity”, which similar to an entrepreneur who invests time and effort building the value of a company later sold for profit under the capital gains rate, represents the “sweat” poured into portfolio companies by GPs.
Many private equity tax lawyers speaking with PE Manager have agreed with this principle, but there is by no means any consensus on the issue. “I provide my sweat equity to my law firm’s business and I take risk and still all of the income I receive is ordinary income,” said in an interview one New York-based tax lawyer. “Same thing for Lady Gaga and Tiger Woods”.
The lawyer elaborated: “The principle is this – services are taxed at ordinary income rates, regardless of whether those services are investment management services, legal services, or entertainment services. Carried interest is one of the only exceptions to that, and the exception was not intentionally granted by Congress, and there is no rational policy reason why the tax system should subsidize investment managers over other service providers.”
On the other hand industry professionals argue that carry is a unique animal in that other payment for services (for example a lawyer’s wages and bonuses) do not get clawed back when the firm experiences a bad year. In contrast, private equity partners risk having to return all distributions made by the fund if investments later turn sour, and must still pay taxes on those recovered distributions to boot.