Tax Equality: Eliminating the Low Effective Marginal Tax Rates for Private Equity Professionals

By Satyanarayana, Shrilaxmi S. | St. John's Law Review, Fall 2008 | Go to article overview

Tax Equality: Eliminating the Low Effective Marginal Tax Rates for Private Equity Professionals


Satyanarayana, Shrilaxmi S., St. John's Law Review


INTRODUCTION

The issue of income classification - ordinary income versus capital gains income - has received considerable media scrutiny in the past eighteen months with respect to private equity funds,1 as large private equity firms have gone public, and information about their management structures and compensation practices have been subject to disclosure.2 Private equity funds are partnerships that invest in companies and/or entire business units, manage them, and then sell them off at a profit.3 The investments in the companies and/or business units generally qualify as capital assets.4 Private equity firms typically retain ownership of their equity stakes for several years.5 Given that the minimum holding period for the sale of a capital asset to qualify for long-term capital gains treatment is one year, the profit received on disposal of these private equity investments therefore takes the form of a long-term capital gain and is subject to lower tax rates than the sales of capital assets that are held for one year or less.6

The general partners of the private equity fund make the investment decisions regarding the companies in which the fund is invested, while the limited partners provide investment capital.7 For their investment decisions, the general partners are compensated in two ways: First, they receive two percent of the assets under management annually as a management fee, on which they are taxed at ordinary income tax rates, and second, they receive 20 percent of the fund's profits, the "carried interest,"8 for which they are often taxed at the lower capital gains rate. The capital gains rate on the 20 percent profit share is permissible under current Internal Revenue Code ("I.R.C.") rules because the partnership itself receives the profits in the form of capital gains, and through pass-through principles, it retains that character when it flows through to the individual partners.9 Given that private equity professionals receive significant remuneration via the carried interest,10 and are taxed at the lower capital gains rate, Congress, in contemplation of legislation subjecting carried interests to the higher ordinary income marginal tax rate, held hearings during the late summer and early fall of 2007 to understand the economics of these arrangements and to understand the arguments both in favor of and against the current tax treatment.11

Private equity professionals assert that their investments are "integral to capital formation and liquidity in this country"12 and contend that imposing a higher marginal tax rate would result in the "sky . . . fallfing] and . . . private equity ... shrivel [ing] up and d[ying]."13 According to these professionals, the imposition of higher marginal tax rates would result in fewer deals getting funded in the United States, hampering the United States' economy.14 In addition, they contend that the current tax treatment is appropriate for encouraging risk taking with respect to funding companies that have difficulty raising capital from traditional sources.15

In contrast, proponents of change to the current tax structure maintain that increasing the marginal tax rate is necessary to ensure equality and fairness.16 Individuals in other high paying professions, such as executives and lawyers, are subject to taxation at the ordinary income tax rate, whereas private equity managers are taxed at the long-term capital gains rate, because their income is structured in the form of carried interests.17 In addition, they claim that warnings of a precipitous drop in private equity funding as a result of proposed tax code changes are spurious, given that private equity managers do not bear risk to the same extent as do entrepreneurs,18 and that many investments tend to be made in a relatively narrow geographic area to facilitate monitoring.19

This Note will evaluate the arguments by both challengers and proponents to tax reform with respect to carried interests and propose two methods to bring about change in the tax treatment. …

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Tax Equality: Eliminating the Low Effective Marginal Tax Rates for Private Equity Professionals
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