Private Equity and Taxes
Like all sophisticated companies, private equity firms aggressively manage the tax liabilities of their own firms and those of their portfolio companies. For example, according to the Financial Times, Blackstone paid taxes at a rate of 1.4 percent last year. If it had been taxed at the 34.5 percent rate that applies to companies such as Goldman Sachs, for example, Blackstone’s tax bill last year would have increased from just $32 million to nearly $800 million.
Policy-makers are focusing on three unique tax advantages enjoyed by private equity firms and their partners:
1. The tax treatment of debt vs. equity
Buyout firms depend on leverage to meet their target returns. One benefit of relying on debt financing to acquire portfolio companies is that buyout firms can deduct their interest costs from portfolio companies’ profits, effectively reducing taxable income. Public companies, which are more heavily financed with shareholders’ equity and often face shareholder opposition to the aggressive use of debt, are generally unable to avail themselves of this tax provision to the same extent. The tax advantages of debt also allow buyout firms to bid more aggressively for acquisition targets than most public companies. According to Jay Ritter, a Professor of Finance at the University of Florida, the “consensus is that [the tax advantages of using debt financing] can add more than 10 percent to the value of a bid” for an acquisition, allowing aggressive users of debt such as buyout firms to outbid potential acquirers that rely more on cash or equity. Tax authorities in the United Kingdom and Germany currently are considering curtailing buyout companies’ ability to deduct interest payments.
2. Taxing carried interest as capital gains instead of income
The primary source of revenue for a successful private equity firm is the percentage of profits earned when portfolio companies are sold or recapitalized. This “carried interest,” which is usually about 20 percent of the profits from the sale of a portfolio company, is retained by the private equity firm as compensation for earning a good return for its investors. The firm then distributes the “carry” to its owners and employees, with the founders and senior partners taking the lion’s share. The firm’s partners do not pay ordinary income tax on their portion of the carry—a rate of 35 percent—but instead pay the lower capital gains tax—a rate of only 15 percent. For example, paying taxes on $1 billion of carried interest at the capital gains rate of 15 percent instead of the typical income tax rate of 35 percent saves private equity principals more than $200 million in taxes. Recent press accounts suggest that members of Congress, including the ranking Republican member of the U.S. Senate Finance Committee, are considering changing the tax regime to tax carried interest at ordinary income tax rates. An anonymous Senate aide was quoted in the Financial Times saying "We are looking into instances where funds may be using tax strategies to convert what would be income into capital gains for tax advantage. "
3. A potential tax-advantaged corporate structure created when private equity firms go public
This year, major private equity firms are beginning to sell shares to the public not just in their portfolio companies, which they have always done to exit their investments, but in the private equity firm itself. Private equity firms considering selling themselves in a public offering may have discovered a creative way to pay lower entity-level taxes than other public companies. Following a path blazed by the hedge fund and private equity firm Fortress Investment Group in its IPO earlier this year, Blackstone Group has announced plans to go public as a master limited partnership. According to Reuters, “under U.S. tax law, master limited partnerships do not pay the 35 percent corporate tax rate, but rather distribute nearly all their profits to common unit holders who individually are allowed to pay 15 percent capital gains tax rates.” “I don’t think Congress had this in mind when it wrote the publicly traded partnership rules in 1987,” Victor Fleischer, a law professor at the University of Colorado in Boulder, told Reuters. He added, “there’s some risk that the IRS could rule against Blackstone and say that the structure isn’t any good, and I think there’s a significant risk that Congress could change the rules.”
Policy-makers are beginning to question whether providing the private equity buyout industry with these tax advantages benefits society as a whole and the overall economy, or whether they simply make it easier for private equity to acquire and profit from companies at the expense of public shareholders and federal and state tax revenues.