The Billionaire Loophole: The Private Equity Tax Escape

by Samuel Bollier

On a walk through Times Square, a pedestrian can expect to see flashing lights, neon signs and Broadway theaters. Less apparent is that more than two dozen companies prominently located in the Times Square area - from the Toys 'R' Us flagship store, to the New York Sports Club, to Burger King - have been bought out by private equity firms in massive leveraged buyouts.

Times Square is "filled with people making $8 an hour, without healthcare, working for some of the wealthiest companies in the world," says Stephen Lerner of the Service Employees International Union (SEIU). Private equity-owned companies with operations in the Times Square area are worth more than $100 billion, according to SEIU estimates, employing more than half a million workers across the United States.

Private equity firms buy publicly traded corporations, reconfigure them, and then sell them back to the publicly traded markets. The top firms have yielded extraordinary financial returns in recent years, and private equity firms have gobbled up ever-larger corporations - two developments that have elevated their profile considerably.

But it is the mammoth compensation paid to the top private equity firm managers - and the fact that they pay taxes at a lower rate than garbage collectors - that has moved them from the business page to the front page.

The Blackstone Group, founded in 1985 by Peter Peterson and Stephen Schwarzman, is one of the biggest players in the burgeoning private equity industry. In July 2007, the firm acquired Hilton Hotels for $26 billion in one of the biggest leveraged buyouts of the year. But perhaps the bigger news was Blackstone's June initial public offering (IPO), by which it sold a chunk of its own stock to the public. While private equity firms typically operate in relative secrecy, the U.S. Securities and Exchange Commission (SEC) mandates disclosures of information for stocks sold on public markets.

Those disclosures were explosive. They showed that Schwarzman maintained a 24 percent stake in Blackstone, valued at $7.7 billion at the time of the initial public offering, grabbed a payout of somewhere around $677 million in connection with the IPO, and earned $400 million in 2006.

Schwarzman is no paragon of frugality: his personal chef is reported to frequently spend $3,000 a weekend on food for Schwarzman and his wife, including crabs for $400 apiece. Employees in Schwarzman's 11,000-square-foot house are forbidden to wear rubber-soled shoes because of their potential to create annoying squeaks. In February, he threw a lavish 60th birthday party for himself, estimated to cost $3 million.

Schwarzman gained attention on the front pages - and in the halls of Congress - not so much for his lavish lifestyle as for his tax avoidance. A loophole in the U.S. tax structure enables him and other private equity and financial titans to pay just a 15 percent rate on their earnings.

The policy dispute over whether that loophole should be closed became one of Washington's hottest controversies in 2007.

The Private Equity Model

Private equity firms collect money from institutional investors, such as pension funds, university endowments and charitable foundations. Using this money, combined with massive loans from banks, they buy out the publicly traded stocks of companies they believe to be undervalued and take them off the market. This period of private equity control lasts, on average, from three to five years, according to the Private Equity Council's vice president for public affairs, Robert Stewart, though it is often far less. During this time, the private equity firm attempts to restructure the acquired company in ways that will increase its market value.

Once these changes have been made, the private equity firm sells the company back to the public stock market. Most of the proceeds from the whole transaction are paid back to the private equity firm's investors. The private equity firm, however, is entitled to an annual management fee of 2 percent of the capital raised. If the company's sale and any dividends paid amount to more than the "hurdle rate" - an agreed-upon rate of return, such as 8 or 10 percent - the private equity firm also earns a performance fee comprising 20 percent of the profits (above the hurdle rate). This performance fee is known as the private equity firm's "carried interest." Together, these two inputs in fund managers' salaries are known as the "2 and 20."

Under existing U.S. tax rules, the manager's carried interest earnings are taxed not as normal income, but as capital gains - earnings accrued from the purchase and sale of assets. The tax rate on capital gains is just 15 percent, whereas the manager's salary would otherwise be taxed at a rate of 35 percent, the top U.S. income tax rate. Some prominent figures in the financial world, such as former Treasury Secretary Robert Rubin, have argued that managers' profits should be taxed as normal salary.

The fact that capital gains - earnings on investment - are taxed at a lower rate than wage and salary income is highly controversial. But there is a theoretical rationale, which aims to incentivize investment that will create new social wealth. Because private equity arrangements are structured as partnerships, private equity managers are able to claim their income as capital gains - just like the investors who put money into the private equity deals.

Critics of the current tax regime, however, point out that private equity firms and hedge funds are primarily providing a service - investing other people's money - for which they are compensated. Thus, they contend, the private equity managers should be taxed at the ordinary income tax rate, just like any other service provider or financial advisor, not the specially reduced capital gains level.

Closing the Loophole

In June 2007, Senators Max Baucus, D-Montana, and Charles Grassley, R-Iowa, the chair and ranking Republican member of the Senate Finance Committee, introduced a bill in that would tax publicly traded partnerships that derive income from asset management services, such as Blackstone, like other corporations. Corporations have the same 35 percent top tax rate as high-income individuals.

Vehicles of investment, according to Baucus, are "changing right before our eyes," and so "the tax code must keep up with the times … or [we] risk the erosion of our corporate tax base."

Grassley argued that publicly traded partnerships are unfairly advantaged as against other publicly traded corporations. "A hallmark of corporate status is access to the capital markets," he said, and thus "it's unfair to allow a publicly traded company to act like a corporation but not pay corporate tax, contrary to the intent of the tax code."

The Baucus-Grassley bill was labeled the "Blackstone Bill" because it would apply only to publicly traded private equity firms like Blackstone. Other leading private equity firms had planned to go public, but pulled back in light of the credit crisis spurred by the subprime mortgage loan meltdown. (Private equity deal-making relies heavily on cheap and easy credit; the private equity business model is thus much less attractive when credit is harder to obtain.)

In the House of Representatives, Ways and Means Committee Chair Charles Rangel, D-New York, and other leading Democrats, including Banking Committee Chair Barney Frank, D-Massachusetts, introduced legislation that would close the carried interest loophole for all private equity firms. The bill would mandate that fund managers in all partnerships, both public and private, pay taxes on their carried interest at the ordinary income tax rate, as opposed to the 15 percent capital-gains rate. As almost all private equity partnerships are privately held, this bill would have a much wider sweep than the Senate bill. The bill's sponsors are quick to point out that the legislation would not affect tax rates on the earnings from investments made with the managers' own money, nor would other investors in the fund - such as pension and retirement funds - be subject to higher taxes.

Private Equity Goes to Washington

In a few short years, private equity has grown exponentially. PricewaterhouseCoopers estimates private equity firms raised more than $400 billion on a global basis in 2006, up from $272 billion in 2005 and $133 billion in 2004. Monied interests of this scale do not passively accept government policy changes that will negatively affect them - especially when the take-home pay of top executives is at stake.

Responding to the tax legislation, which Chair of the Coalition of Private Equity Companies John Chanos says has "come upon us like a tsunami," private equity firms have poured millions into lobbying operations. From a modest Washington presence in 2006, private equity has become among the biggest lobbying interests inside the Beltway in 2007. Four of the biggest players in the industry - the Carlyle Group, Blackstone, KKR and TPG Capital - formed the Private Equity Council early in 2007, soon joined by an additional seven firms.

Private equity firms spent $2.9 million lobbying in 2006, and just over a million dollars as recently as 2004. In just the first six months of 2007, they spent more than $7 million. These figures refer only to the monies spent on lobbying operations, not on associated public relations efforts designed to forestall tax legislation. Blackstone is by far the biggest lobbying force among the private equity firms, spending $3.7 million in the first half of 2007. During the same period, KKR spent $540,000, the Private Equity Council $660,000, TPG $480,000, Carlyle $260,000, JC Flowers $300,000 and Bain Capital $100,000. All together, private equity firms employ at least 123 lobbyists, according to disclosure forms filed with the U.S. Senate.

Private equity executives are also investing heavily in electoral politics. They donated $5.3 million in the 2006 election cycle, and have already contributed $6.2 million in the 2008 election cycle. Fifty-eight percent of these donations go to Democrats.

A big part of what these new private equity lobbyists and PR shop representatives are trying to do is rehabilitate private equity's reputation. Private equity is essentially a new name for what were called leveraged buyouts during the Michael Milken-heyday in the 1980s. Leveraged buyouts were associated with pension raids, mass layoffs and the break-up of venerable companies - the same criticisms have been lodged against present-day private equity deals [see "The Predators' Ball Resumes"].

The Private Equity Council's Stewart says the group was created in order to do a "better job of telling the industry's story." With the increasing attention paid to private equity, he says, it is important to highlight private equity's role in "supporting American economic competitiveness, strengthening companies, creating value and delivering superior returns to its limited partners." He strongly disagrees with the notion that private equity fund managers are somehow paying a special tax rate, arguing instead that "it is simply wrong to say that there is a tax loophole for private equity." Capital gains rates apply to anyone who shares ownership in an asset, says Stewart, and this state of affairs did not come out of the blue; instead, it "was a policy decision by Congress to encourage investment."

The lobbyists' first-line argument is that private equity is good for the United States. While critics say private equity firms gut companies, the industry says it builds them up. "Most people don't understand [private equity's] role in taking companies, rehabilitating them, and putting them back in the market," says Akin Gump lobbyist Smith Davis.

"Winning private equity strategies must differentiate themselves on the basis of fundamental business improvements that are often more difficult to achieve by current managers working under the constraints of public ownership," argues a Private Equity Council briefing paper. The council argues that private equity firms make long-term investments in the companies they acquire, sacrificing short-term earnings - something possible only if management has "a reprieve from quarterly earnings pressure." Private equity firms bring financial sophistication, and more efficient management personnel and styles (though in fact they often keep previous managers in place), according to the council.

Private equity spokespeople emphasize the high returns that leading firms have generated in recent years - 39.1 percent for the top quartile of firms - and note that pension funds, foundations and university endowments are among the main investors in private equity deals. "The largest category of investors benefiting from these exceptional returns have been public and private pension funds, leading public and private universities, and major foundations that underwrite worthy causes in communities across the country," testified Bruce Rosenblum, chair of the Private Equity Council, before the House Ways and Means Committee in September 2007.

In addition to positioning private equity on the side of angels, the industry has made a series of narrower and more technical arguments to justify the low tax rate for private equity managers.

Private equity funds are structured as partnerships, they say, which are properly taxed at the capital gains rate if their essential activity involves capital investment. The limited partners that invest in private equity funds clearly merit capital gains treatment, and the fund managers are essentially undertaking the same activity as the investors.

Private equity managers, testified Rosenblum, "bear many types of entrepreneurial risk" - an operative principle for rationalizing lower capital gains rates. "Like other entrepreneurs," private equity managers "contribute ideas, expertise and years of effort to the private equity partnerships they form and own. Like other entrepreneurs, these sponsors [the private equity firms] (and their individual partners) bear the risk that this investment will not result in any significant value."

Proponents of taxing private equity at the normal income tax rate say these arguments are misplaced. At a July 31 Senate Finance Committee hearing on the bill, Joseph Bankman, a Stanford University professor of law and business, argued that "one problem with this argument is that fund managers do not perform the same functions or face the same obstacles as entrepreneurs. An entrepreneur may work for years with little or no pay, betting her entire economic future on the success of her idea, invention or efforts. Fund managers perform intermediation and advisory services. They receive generous management fees and benefit from the performance of a portfolio of companies, the success of each of which is dependent on the inspiration and efforts of the entrepreneur."

Some defenders of the low tax level for private equity also contend that applying standard tax rates will undermine U.S. competitiveness. "Foreign governments have learned that ample supplies of capital are the key to creating the rising incomes and economic growth their people are demanding," writes John Rutledge, an economist and private equity manager in a report commissioned by the U.S. Chamber of Commerce. "They are becoming more capital friendly every day, changing tax and regulatory policies to reduce risk and increase returns for foreign investors who bring capital to their countries. They are waiting for us to make a mistake that would drive our capital offshore and into their welcoming arms."

The private equity industry has also worked to rally other business sectors, such as hedge funds and real estate firms, to lobby against the private equity tax bills. These businesses are also typically structured as partnerships and would be affected. The Real Estate Roundtable, a group representing the real estate industry, has actively campaigned against proposals to end the capital gains treatment for carried interests, and has encouraged its members to contact Members of Congress. Many managers of hedge funds also oppose the bills, as they also receive a "2 and 20" salary, with the carried interest taxed at the 15 percent capital gains rate. Other opponents of the legislation include the Managed Funds Association, the Securities Industry and Financial Markets Association, the National Association of Real Estate Investment Trusts and the International Council of Shopping Centers.

But all of the framing arguments notwithstanding, defenders of the low tax rate for private equity managers and other partnerships face a huge public relations problem. As the AFL-CIO's Damon Silvers notes, "It's finally dawned on people that the richest Americans aren't paying any taxes."

The Loophole Lives, For Now

But a strong populist rationale for legislation is not sufficient to lead to action. The heavy investment by private equity firms appears to have yielded results.

Notably, leading Democratic senators with close ties to Wall Street and the finance industry have opposed or questioned efforts to close the private equity tax loophole.

Senator John Kerry, D-Massachusetts, prominently raised concerns about the effects of higher taxation on other types of partnerships that pay capital gains rates, such as real estate trusts. Kerry urged the Senate to "proceed with caution to avoid unintended consequences."

Meanwhile, Senator Charles Schumer, D-New York, has outright opposed the Baucus-Grassley legislation, arguing it would unfairly treat public partnerships differently from other partnerships. "If we're going to change how we tax financial partnerships," he says, "we should treat oil and gas and venture capital and real estate and everything else the same." Schumer says he is defending local New York business interests. Many others charge he is responding to donor interests. The Washington Post reported in November 2007 that Schumer solidified his position shortly after hedge fund managers contributed more than $50,000 to the Democratic Senatorial Campaign Committee, which Schumer chairs.

By Fall 2007, it appeared the proposals to tax private equity at ordinary income tax rates were doomed.

But the proposals were revitalized by a compelling argument to complement the equity claims of proponents: taxing all private equity and other investment management services as ordinary income would raise substantial revenues. The nonpartisan Joint Committee on Taxation estimated it would raise $26 billion over the next decade. Others have estimated the revenue gains would be significantly higher.

A top tax priority for Democrats in 2007 has been adjusting the Alternative Minimum Tax, so that middle- and upper-middle-income earners would continue to benefit from tax deductions and credits. But making the adjustment will cost the Treasury, and current Congressional rules require legislation that raises expenditures or reduces revenues to be offset by equivalent savings or revenue raisers. That made the proposal to tax private equity and financial firms at the 35 percent rate very attractive.

In November 2007, the House of Representatives voted to close the carried interest loophole and impose the ordinary tax rate on private equity and financial firms.

In December, however, the Senate abandoned the proposal, when Majority Leader Harry Reid, D-Nevada, announced he could not win sufficient support to overcome a filibuster. Forty-six senators, all Democrats, voted to close the loophole and support other measures that would make the wealthy pay more.

"There's been a gigantic effort on the part of Wall Street to lobby this issue; they've hired every Tom, Dick and Harry, and they've put on every former Grassley staffer they could," Senator Grassley told the Washington Post. "It has had an impact."

But few expect the issue to go away. And the AFL-CIO's Silvers notes that while there are "some very influential people in the [Democratic] Party who are influenced by the hedge fund and leveraged buyout money, all three major Democratic candidates endorsed the Levin-Rangel approach" - the tougher House version that would do away with the carried interest loophole for all financial partnerships.