Door Opens to Ending a Huge Tax Break

Article excerpt

A decision by a U.S. appellare court in Massachusetts has set the stage for a challenege to a lower rate for some profits of buyout firms.

A recent court case has given the U.S. government a chance to sidestep Congress and eliminate private equity's billion-dollar tax break. The question is whether the Obama administration will take up the fight.

At issue is "carried interest" -- a term that refers to the profits that a private equity adviser makes from investing in companies. Because of what critics term a loophole and private equity firms call common sense, such income is taxed at the capital gains rate of 20 percent instead of as income, which would put it at a maximum of 39.6 percent. That tax treatment has meant that the heads of private equity firms like Stephen A. Schwarzman of the Blackstone Group pay billions of dollars less in taxes.

This apparent inequality has led many to protest. After all, why should these private equity barons, many of whom are extraordinarily wealthy, get to profit to the tune of extra billions? Even Mr. Schwarzman's co-founder at Blackstone, Peter G. Peterson, has come out against the tax break, stating he "can't justify that."

In defense, private equity advocates like the Private Equity Growth Capital Council argue that the profits are investment income and that to change the tax code would mean private equity firms would have less of an incentive to invest, upending a policy that "has helped America prosper for more than 100 years."

Unswayed, the Obama administration has tried repeatedly to tax private equity profits as income, which would raise an estimated $16 billion extra over a decade. The rabid anti-tax fervor in Congress, however, has prevented any change.

Now, a court case involving the private equity firm Sun Capital Partners has unsettled the entire treatment of carried interest. Sun Capital specializes in buying and selling distressed companies. The case arose out of its $7.8 million buyout in 2007 of Scott Brass, a manufacturer of high-quality brass and copper used in electronics and other products. About a year after the takeover, Scott Brass sought bankruptcy protection. Sun Capital sued the company's pension fund seeking a judgment that it was not liable for $4.5 million of the company's pension.

Under the pension laws, Sun Capital would be responsible for this amount if Scott's employees were under the control of Sun and Sun Capital's funds were engaged in a "trade or business."

The pension fund argued that the Sun Capital funds were liable because the funds were engaged in the trade or business of operating Scott. Sun Capital argued the opposite, saying that it was merely a passive investor. The U.S. Court of Appeals for the First Circuit in Massachusetts sided with the pension fund, ruling this summer against the two Sun Capital funds involved in the buyout.

The court determined that the Sun Capital funds were arguably involved in a "trade or business" through their ownership of Scott because the funds were "actively involved in the management and operation of the companies in which they invest." The decision also went up the chain through the legal entities to hold the firm responsible.

What does this pension fund case have to do with carried interest?

Well, to take advantage of capital gains treatment for carried interest, private equity firms must also satisfy rules that they are not engaged in a "trade or business" in operating the company they own. …