Friday, July 13, 2007

Taxing Private Equity

Not too long ago, I asked an accounting colleague about the tax treatment of someone selling things on an auction site like Ebay. Suppose you are making your living buying and selling collectibles on Ebay. How does the income you make get treated for tax purposes -- is it normal income, or is it capital gains? The difference, of course, is very large, as capital gains are taxed at 15% and normal income at higher rates. Similar analogies came to mind: how about a used car dealer? If I buy and sell cars, is the money I make a capital gain or normal income? It seemed like one of those issues where tax law would draw a somewhat arbritrary line. I can see an argument that if you are essentially a dealer, i.e., making a market in a collectible, then your income could be considered normal, rather than a capital gain, as you are essentially being rewarded for the service of providing a market. But it is going to be a tough call, and in some sense, illustrates the arbitrariness of treating income differentially to begin with.

Now comes the tax issue with the partners of private equity funds. Is the money that private equity fund managers make better considered to be normal income or a capital gain? This is a great topic for discussion. The current law may well make it legal for the managers to use capital gains rate; I suspect if they are doing it, they have had great lawyers look into the legality. So the question is what the right legal tax treatment should be.

But along comes the New York Times yesterday, with a front page story on "Tax Loopholes Sweeten a Deal for Blackstone." The intent of the story is clear -- to raise all kinds of shady questions about the tax fairness of aspects of the Blackstone IPO. The tactics are the usual combination of insinuation, vague claims, and muckraking language. Here are some examples:

"“These guys have figured out how to turn paying taxes into an annuity,” Ms. Sheppard said. “What people don’t realize is
that the private equity managers, the investment bankers, all the financial intermediaries, are in control of their own

"The Blackstone partners sold the good will from their left pocket to their right."

"The ability to provide answers to such questions is why tax lawyers can typically charge $700 an hour or more. Just as
fashion designers blend textures, colors and shapes, tax experts mix and match elements of partnerships and
corporations, and bits and pieces of the tax code, securities laws, accounting rules and economics principles."

There are some interesting issues in the Blackstone deal. But this NYT story leaves me clueless as to what actually is going on, and whether it is at all questionable. Some more facts and clear language on what is being done would go SO much further than the kind of language pointed out above. The "annuity" that is referred to seems to be nothing more than the fact that if the goodwill can be written off against income in future years, then of course it creates a tax saving (assuming there is positive income). And to say that private equity managers are in control of their own taxation is really a stretch.

Well, I guess I am in control of my taxation too. If I earn less money, I will pay less tax.

1 comment:

ilanit said...

Investments in limited partnership interests (which is the dominant legal form of private equity investments) are referred to as Orange County equity investment which should earn a premium over traditional securities, such as stocks and bonds. Once invested, it is very difficult to gain access to your money as it is locked-up in long-term investments which can last for as long as twelve years. Distributions are made only as investments are converted to cash; limited partners typically have no right to demand that sales be made.