The taxation of private equity carried interests: estimating the revenue effects of taxing profit interests as ordinary income.

• Author: Knoll, Michael S.

ABSTRACT

In this Article, I estimate the tax revenue effects of taxing private equity carried interests as ordinary income rather than as long-term capital gain as under current law. Under reasonable assumptions, I conclude that the expected present value of additional tax collections would be between I percent and 1.5 percent of capital invested in private equity funds, or between $2 billion and $3 billion a year. That estimate, however, makes no allowance for changes in the structure of such funds or the composition of the partnerships, which might substantially reduce tax revenues below those estimates.

TABLE OF CONTENTS INTRODUCTION I. THE STRUCTURE OF PRIVATE EQUITY FUNDS II. THE TAXATION OF PRIVATE EQUITY FUNDS III. ESTIMATING THE REVENUE CONSEQUENCES OF TAXING CARRIED INTERESTS AT ORDINARY INCOME TAX RATES IV. CONVERTING THE ESTIMATES FROM PRESENT VALUES INTO DOLLARS A. The Additional Tax Revenue from Changing Both the Character and Timing of Taxation B. The Additional Tax Revenue from Changing Only the Character of Taxation V. CHANGING THE STRUCTURE OF PRIVATE EQUITY FUNDS A. Loans from Limited Partners to the General Partner B. Converting Limited Partners into Creditors C. Transferring Deductions to Portfolio Firms D. Summary VI. CHANGING THE COMPOSITION OF PRIVATE EQUITY PARTNERSHIPS VII. THE JOINT COMMITTEE'S TAX REVENUE ESTIMATE CONCLUSION INTRODUCTION

The controversy over the tax treatment of carried interests held by the managers of private equity funds continues. Private equity firms receive a share of the profits--typically 20 percent--earned by the funds they manage. Under current law, the owners of private equity firms are taxed at capital gains rates--generally 15 percent--on those profits. As a result, Warren Buffet and others have noted that the principals of some of the most successful private equity firms pay a smaller share of their income in taxes than do many middle-income Americans. (1) In the summer and fall of 2007, the newspapers were filled with editorials and opinion pieces on the tax treatment of carried interests. Most of these pieces argued that carried interests are compensation for services and should be taxed as ordinary income. (2) Many of these pieces characterized the current tax treatment of carried interests as a massive giveaway. (3) In the summer of 2007, Congress held hearings on the tax treatment of private equity. (4) Except for representatives from the private equity industry, most of the witnesses urged Congress to tax the managers of private equity funds more heavily. (5) Academics are also writing about the tax treatment of private equity. (6) Most academics are urging Congress to tax carried interests as ordinary income. (7) As Victor Fleischer noted in July 2007, there appears to be an emerging consensus among all but the private equity industry itself that the tax treatment of carried interests is unjustifiably low. (8) Yet there are other voices emerging. In addition to those of the private equity industry with its dire predictions of the consequences of taxing carried interests as ordinary income, (9) more measured voices are beginning to see as more complex the tax and economic issues such a change would uncover. (10)

The stakes in the debate over carried interests were raised substantially when Representative Charles Rangel (D-N.Y.) linked the tax treatment of carried interests with reform of the alternative minimum tax (AMT). (11) Almost four million taxpayers paid the AMT in 2007. (12) Because it is not indexed for inflation, the AMT would have ensnared an additional 20 million taxpayers that year; each year, however, Congress has voted to index the AMT for the current year. (13) The annual cost of the AMT patch is now roughly $50 billion. (14) Under the pay-as-you-go budgetary rules that Congress adopted in 2007, tax cuts and expenditure increases must be offset with other tax increases. (15) Later that year Representative Rangel proposed using the tax revenue from a permanent tax increase on carried interests to pay for permanent AMT relief. (16) Accordingly, the more revenue collected from holders of carried interests, the smaller the amount of additional revenue Congress would have to come up with from other sources to pay for AMT relief. (17)

In the wake of Representative Rangel's linking of AMT relief to carried interest reform, I posted the first draft of this manuscript on the Social Science Research Network (SSRN). (18) That draft contained revenue estimates for a proposed tax increase on holders of carried interests. (19) A few days later, Ryan Donmoyer of the Bloomberg News Service wrote an article on Bloomberg.com summarizing my study and describing its significance for the ongoing debate over how to tax carried interests. (20) Those revenue estimates soon became part of the discourse. (21) A spokesman for Congressman Rangel described my numbers as lower than expected, but indicated that the Congressman still planned on proceeding with his proposed legislation because he viewed it as "a basic issue of fairness in the tax code." (22) A lobbyist hired by a prominent private equity firm, on the other hand, commented that my study showed that Representative Rangers proposal would not be a "simple and clean" fix. (23)

Then, in October 2007, the Joint Committee on Taxation (JCT) came out with its own estimates of the additional revenue that would be raised if carried interests were taxed at ordinary income tax rates. (24) Those estimates were in the same ballpark as my earlier estimates. The government's estimates, however, were not supported with any public explanation. The JCT simply released the figures.

All parties with a stake in the carried interest controversy have an interest in understanding how much additional revenue will be collected if the taxation of carried interests is changed. Accordingly, in this Article, I attempt to quantify the tax benefit to private equity managers of the current treatment of carried interests and the additional tax revenue that the Treasury would collect if that treatment were reformed. I also explain the basis for my calculations, which the JCT failed to do, and respond to some comments about my earlier draft.

The remainder of this Article is organized as follows: Part I describes how private equity funds are organized, and Part II describes how participants in such funds are taxed. Part III estimates the additional revenue that would be collected if carried interests were taxed at ordinary income tax rates. The estimates in Part III assume that neither the structure of private equity funds, nor the composition of investors in those funds, change. In addition, in Part III I calculate the additional tax as the expected present value as of the date the partnership makes its investments of the additional tax revenues. Part IV converts the estimates generated in Part III into current tax dollars at the date of collection. These figures are what Congress uses for budgetary purposes. The next two parts describe changes that are likely to occur if Congress raises the tax on private equity, which will blunt the impact of those increases. Part V describes various ways in which the structure of private equity funds is likely to change, and Part VI discusses how the composition of investors in private equity funds is likely to change. Part VII discusses the JCT's revenue estimates.

1. THE STRUCTURE OF PRIVATE EQUITY FUNDS

   Private equity funds raise capital in order to purchase and invest in new and existing businesses. (25) These funds are private in the sense that the ownership interests are not traded on the public stock exchanges. (26) Instead, private equity funds raise capital outside of the public markets by going directly to investors. (27)

   Private equity funds can be divided into two broad categories: buyout funds and venture capital funds. (28) Buyout funds generally purchase established companies or divisions of established companies. (29) They acquire these companies for cash, often increasing their debt level, and seek to restructure and improve the acquired businesses. (30) In contrast, venture capital funds generally invest in start-up businesses. They seek to make early and mid-stage investments in businesses that are trying to commercialize new and developing technologies. (31) Venture capital funds thus invest in smaller, riskier businesses than do buyout funds, and they tend to invest in more companies than do buyout funds. (32)

   Whether it is a venture capital or a buyout fund, the typical private equity fund is structured as a partnership or a limited liability company. (33) The fund's investment capital comes from its limited partners. (34) These investors are often wealthy individuals, charitable foundations with large endowments, pension funds, and some corporations, especially insurance companies and banks. (35) The private equity fund is managed by a private equity firm. (36) The private equity firm is also the fund's general partner and it decides which investments the fund will make. (37) Although the limited partners provide nearly all of the fund's capital, (38) they do not contribute all of that capital when they enter into the partnership. Instead, they commit to invest a certain amount of capital over time. That period of time, called the investment period, might continue for five to six years. (39) Over the investment period, the general partner calls upon these commitments when the partnership makes investments in portfolio companies. (40)

   Once they have satisfied a capital call, the investors in a private equity fund generally have little or no liquidity with respect to their investment. (41) The limited partners typically have no right to sell, transfer, or redeem their interests. (42) Instead, the limited partners are compensated as the fund disposes of its investments either by selling the companies and distributing the proceeds to the investors, or by taking the...