Taxing Private Equity: The Battle on Capitol Hill

Private-equity and hedge fund managers, who can make millions of dollars, pay taxes on most of their earnings at the low capital-gains tax rate. But some in Congress want to make them pay a higher rate, like most corporations pay. And that has the industry gearing up for a major fight with Congress.

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Private equity and hedge fund managers are viewed by many as the new lions of Wall Street. When the private equity firm Blackstone held its IPO last month, Steve Schwarzman, the founder and CEO, wound up with an ownership stake valued at $8 billion. Schwarzman earned nearly $400 million last year. Congress has taken noticed. And now there are efforts in the House and Senate to boost taxes on private equity firms. But raising taxes on private equity raises a number of thorny questions.

NPR's Jack Speer reports.

JACK SPEER: Private equity firms buy companies perceived as being undervalued, fix them up and then sell them, usually at a profit. Most of that money goes to investors, but a slice, typically about 20 percent, is kept for the firm and its general partners. The payouts can be enormous, with individual managers taking home hundreds of millions of dollars.

Bob McIntyre, the head of Citizens for Tax Justice, says these managers are taxed at a lower rate than the receptionist who answers the phone in the firm's front office.

Mr. BOB McINTYRE (Citizens for Tax Justice): Much lower. I mean if you're an ordinary working person, you pay the Social Security and Medicare taxes for starters, which is 15 percent. And then you're either in the 15 percent or 25 percent tax bracket, so these guys are paying anywhere from half as much to a third as much as ordinary working people.

SPEER: There are several proposals in Congress to rewrite the tax laws. Rather than the 15 percent capital gains rate at which private equity firms are now taxed, a House bill would require all partnerships to be taxed at a rate more than double that amount. A Senate bill would also sharply increase the tax rate for private equity to 35 percent, though it would only apply to firms that go public like Blackstone. But not everyone in Congress thinks rewriting the tax laws to single out private equity is a good idea.

Representative Eric Cantor, Deputy Republican Whip in the House, has come out solidly against the proposal to further tax private equity.

Representative ERIC CANTOR (Republican, Virginia): This is not just an issue for folks working on Wall Street. This really is an issue that will, in the end, impact blue jean-wearing Americans.

SPEER: Cantor, who like many of his colleagues in Congress has received campaign contributions from private equity firms, says changing the tax rate would have unintended consequences. Under the current rules, capital gains are taxed at a lower rate to encourage investment, and Cantor claims rewriting the tax code for just one type of business, private equity, will likely be just the first step for gracing the rate for everyone.

Rep. CANTOR: This really is not just about private equity. This is really about taxing innovation and job creation in America, and I think it really is the first salvo of those who wish to get rid of the rate reduction on the cap gains tax that we have in this country.

SPEER: But some tax experts believe those concerns are overblown. Victor Fleischer is a law professor at the University of Illinois who studies private equity. He says private equity managers invest other people's money, not their own. And he says they perform real work and therefore should be taxed more like a company.

Professor VICTOR FLEISCHER (University of Illinois): I think it's a tricky issue. I don't want to oversimplify it, but it's an anomaly, I think, when you see people getting taxed at lower rates on what at least has strong elements of compensation income, as opposed to investment capital.

SPEER: And let's say Congress did pass a bill and President Bush decide to let it stand. There are still big questions about how much revenue the government would actually collect.

Josh Lerner, a professor at Harvard's Business School, says if they lose, private equity firms won't just pull out their checkbooks. They'll get creative.

Professor JOSH LERNER (Harvard Business School): Instead of relying on the traditional set of compensation, could simply figure out a way where they simply assign themselves a small amount of the stock in the companies that they're financing and in all likelihood get around some of the provisions as they're laid out.

SPEER: In the meantime, the industry plans to fight and it will have plenty of resources to draw upon. More congressional hearings on private equity taxation are expected.

Jack Speer, NPR News, Washington.

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