Government

Why The Private-Equity Guys May Soon Pay More Taxes

Happy tax day!

Let's talk about carried interest. In other words: Why is a lot of the money private-equity fund managers make taxed at 15 percent (as capital gains), rather than at 35 percent (as income)?

Much to the chagrin of the private-equity industry, this question has become a perennial topic of discussion in Washington.

The House keeps passing bills that would change the tax rules, so that private-equity managers would have to pay 35 percent. The Senate has yet to go along, but Bloomberg News reported yesterday that key Senators are showing more interest.

The shift would raise about $25 billion over 10 years.

The issue popped up a few years back, when a tax-law prof named Victor Fleischer wrote an academic paper arguing that "this quirk in the tax law allows some of the richest workers in the country to pay tax on their labor income at a low rate."

Many private-equity managers are paid under a structure popularly known as "two and twenty": They get a paid a fee that's two percent of the assets under management, and they also get to keep 20 percent of the profits from their funds. That 20 percent is carried interest.

Here's a wildly oversimplified example. Imagine that investors — pension plans, endowments, whatever — put $100 million into a private-equity fund. The fund turns a profit of $15 million. The people who run the fund would get $2 million as a management fee, plus $3 million as a share of the profits.

The $2 million is taxed as income; the $3 million is taxed at the (much lower) capital gains rate.

David Weisbach, a tax prof at the University of Chicago, argues that this is appropriate.

If the private equity guys borrowed the money, invested it, and made a profit, everyone would agree that the profits should be taxed as capital gains — that's what the capital gains tax is for, Weisbach told me this week.

In private-equity funds, the investors' money is structured as equity, rather than debt. But that shouldn't make a difference for how the profits are taxed. "A fundamental economic idea is the type of financing should not affect the taxation," he said. (For more, see this Weisbach paper, which was funded by a private-equity industry group.)

Fleischer comes at it from a different angle: Basically, he argues, carried interest is what private-equity managers are paid for doing their job. So it's income, and should be taxed as income. The only reason it's not, he argues, is because the relevant part of the tax code is out of date.

"The tax rules were written in 1954, and we didn't even have significant private equity funds back then," he told me this week. "Now we've got billions of dollars flowing through."

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