Tax equity: Changing the law would force private equity firms to pay their fair share.

Friday, December 11, 2009

ANYONE SEEKING evidence that the U.S. tax code is out of whack need look no further than the arcane provisions dealing with private-equity funds. For years, the general partners in these investment firms have paid taxes on much of their earnings at a top rate of just 15 percent, as opposed to the maximum rate on ordinary income, which is now 35 percent. The result is that some individuals in some years have reaped hundreds of millions of dollars but paid taxes on them at a lower rate than many middle-class couples. Private-equity firms have successfully staved off past efforts to correct this anomaly. But President Obama supported such a change in his fiscal 2010 budget, and an otherwise routine extension of tax breaks just approved by the House contains a provision authored by Rep. Sander Levin (D-Mich.) that would eliminate the differential.

The case for reform is strong. Private-equity firms, like other investment partnerships, usually collect 1 or 2 percent of their assets under management as an annual fee, taxed as ordinary income. But the really big bucks come as "carried interest." This is the general partner's share, often about 20 percent, of the fund's profits (assuming they exceed a certain "hurdle rate"). In the case of a $150 million annual profit, the general partner would take $30 million, with the investors splitting the remaining $120 million. Under current law, the investors pay the capital gains tax -- 15 percent -- on their share of the winnings, which makes sense since they put money at risk. But the general partner also pays the capital gains rate on his "carried interest," even though his contribution to the fund's success consisted of ideas and effort, not any actual cash. Many economists and tax experts consider it far more realistic to think of the general partner's take as ordinary income -- compensation for services rendered, basically -- which should be taxable at the 35 percent rate.

The private-equity industry argues that a change in the law would upset expectations upon which a dynamic industry has been built -- along with similar partnerships in venture capital, real estate and energy. No doubt, but it's hard to argue that the difference between taking home a super-sized pile of money and a merely large one would destroy any incentive to engage in truly economically justified investments. In the meantime, the tax code would be made fairer in reality and appearance -- assuming Congress can prevent firms from gaming the new rules -- and the government would gain billions of dollars in revenue at a time when every little bit of deficit reduction helps.

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