Blackstone's IPO structure is a nifty piece of tax engineering. Under current law, it will probably qualify as a publicly-traded partnership, which will allow it to maintain two key tax advantages: (1) the capital gains preference on carried interest distributions, which I address in Two and Twenty, and (2) the ability to pass income through to investors without incurring an entity-level tax. Blackstone's impressive IRRs depend, in part, on the availability of these tax preferences.
Although I think Blackstone's structure probably works under current law, there's a significant political tax risk. These rules aren't set in stone, and the Blackstone deal is the kind of deal that could stir Congress to act.
Taxing Carry as Ordinary Income? One possibility is that Congress could change the partnership tax rules. A couple of weeks ago, before Blackstone filed, the news from Capitol Hill was that the Senate Finance Committee was interested in revisiting the tax treatment of carried interest distributions. The Private Equity Council, a newly-formed private equity lobbying group, has taken up this issue.
The revenue implications are significant. The tax writing committees are looking for revenue offsets to free up space for other tax policy reforms, like easing the burden of the AMT on the middle class. It could find a large revenue bump from treating carry as ordinary income, taxing it at 35% rates instead of 15% long-term capital gains rates. Congress could also raise revenue by treating all income to fund managers, including carry, as employment income. Treating carry as employment income would subject that income to another 3% or so in state and federal payroll taxes. (Social security payroll taxes are capped at $90,000 of income, but Medicare taxes aren't capped.) If there's, say, a trillion dollars of capital in private equity, generating a 15% annual return ($150 billion), and fund managers get 20% of that return ($30 billion), raising the rates by 20% would produce $6 Billion in additional tax revenue. Over ten years, and discounting to present value, that could generate about $42 billion. Not trivial. I also think I'm underestimating the carry; Blackstone alone earned $2 billion last year, much of that in the form of carried interest distributions.
(This estimate also doesn't count hedge funds. Because many hedge funds generate ordinary income and short term capital gains, the revenue implications are much smaller. To the extent that hedge funds are acting more like private equity funds and taking strategic positions in companies which they hold for more than a year, however, there is certainly some revenue potential.)
Cost of Capital Method. In Two and Twenty, I introduce a "cost-of-capital" method of taxing carry that would represent a compromise between treating carry as a return on human capital (labor income) and a return on investment capital (reflecting the sweat equity investment of fund managers). Under that approach, the basic 20% carry structure would be treated as a non-recourse, zero interest rate loan of 20% of the capital of the fund, which fund managers then invest in the fund. The fund managers would then recognize, as ordinary income, an annual charge on the forgiveness of the imputed interest on the imputed loan; further appreciation of the fund investment would retain its character as capital gain. If there's a trillion dollars of capital in private equity, you'd have $200 billion of imputed loans to fund managers, times a 6% interest rate, times 35%, or $4 Billion a year in additional tax revenue. Over ten years, would mean about $28 billion present value in revenue.
Changing the publicly-traded partnership rules? The Blackstone IPO raises the stakes by threatening the integrity of the corporate tax base. If Blackstone's structure works, then other financial intermediaries may be tempted to adopt the structure as well as an alternative to going public as a corporations. And firms like Goldman Sachs, which went public as a corporation, may be tempted to split-off portions of their business as publicly-traded partnerships. Congress has been willing, to some extent, to extend pass-through treatment to the real estate, mutual fund, and oil and gas industries, but extending this treatment to active, strategic investors is new territory. Changing the rules (both with respect to carry and PTPs) may be necessary not just to raise revenue, but just to preserve the current tax base.
The Wall Street Rule. Ironically, if the private equity industry moves aggressively enough in adopting the publicly-traded partnership structure, tax reform becomes more difficult. The Wall Street Rule, a rule of thumb used in the taxation of securities context, holds that after enough investors have developed expectations of a given tax treatment (say, that a given security will be treated as debt and not equity), the IRS will not upset those expectations, even in the absence of published guidance. The IRS, of course, disclaims the legitimacy of the Wall Street Rule, as it must. Given its institutional constraints, the IRS can't be expected to act quickly on every new deal structure that comes along. But there is also little doubt that it becomes politcally more difficult to act as more and more investors act in reliance on the tax treatment promised in the prospectus. This shouldn't come as a surprise; at the moment, there are only a few thousand professionals with a direct financial interest in maintaining the status quo method of treating carry as capital gain. As more companies go public, all of their investors attain a financial interest in the status quo. It's much easier to raise taxes on a few thousand super-rich investment professionals than hundreds of thousands of investors.
Related Post: Blackstone IPO: The Tax Analysis
Related Post: Blackstone IPO: Regulatory Arbitrage
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1. Posted by Michael Guttentag on March 26, 2007 @ 21:20 | Permalink
This is a wonderful and helpful series of blog posts. One issue that interests me is what you describe under the heading “Changing the publicly-traded partnership rules?”
We know that access to public securities markets is costly for a variety of reasons. You point out that another potential cost of going public is the loss of various favorable tax treatments. As I understand it, if Blackstone fails in attaining the publicly-traded partnership treatment they seek, this would mean that going public would be quite costly. No doubt these potential tax consequences of going public are much greater than the various compliance costs, such as those required to comply with Sarbanes Oxley.
So my question is this: why are those who are concerned about the competitive disadvantages to our securities markets caused by regulations imposed exclusively on public companies not more concerned about interactions between the Tax Code and going public. If you are correct, it appears we face a difficult choice: either many finance organizations face a substantial “going public” penalty, or an important component of our corporate tax base may be in jeopardy. Perhaps to create a more equitable environment for public equities we need to change the way we tax private financial entities.
2. Posted by anon on March 26, 2007 @ 22:13 | Permalink
It's misleading to call corporate taxation a "going public" penalty. It depends upon the overall rate structure, the differential between corporate and individual rates, and the company's individual tax profile (loss or gain). In certain periods in history, the corporate tax could be described as a tax shelter. Even with the same top corporate rate as individual rate today (except for certain domestic manufacturing companies), it will still be advantageous in certain circumstances.
3. Posted by Vic on March 27, 2007 @ 13:22 | Permalink
Mike - great question - while anon is right that on occasion getting taxed as a C Corp isn't so bad, it usually IS that bad. There is indeed a tax penalty for going public. Putting it another way, there is a categorical tax subsidy for staying private. That's hard to justify, and undoubtedly distorts the market to some extent.
As to why more academics don't focus on the tax costs of going public, I'm not sure - but I've heard that not everyone finds tax as interesting as I do. Crazy, I know.
Whether we ought to address this by stiffening the taxation of private entities or moving toward integration of the corporate and shareholder-level taxes on public entities is an open question. Maybe both.
4. Posted by bsdwork on July 16, 2007 @ 17:55 | Permalink
A very smart move from the KKR's part, as their stock sales will most surely reflect in their working capital and will not just stop there. A move like this really puts you up in the spotlight. Unlike Blackstone, their investors returning the funds will not affect them, as because the investors would not be participating in KKR's carried interest in the fund.
5. Posted by David Johnston on October 18, 2008 @ 4:07 | Permalink
House Bill 545 has taken comfort in the mind of Ohio’s governor, Ted Strickland. He is on the move to convince people in his state to vote in favor of the bill. Ignoring the voice of the people earlier this year, this bill will put a cap on the annual interest rates that no fax payday loan companies can charge to 36 percent. Now let’s review this situation in a bigger picture. This would mean the payday loan industry will make virtually no money at all, which will eventually drive the whole industry out of the state. No company can survive under these conditions. To make matters worse, presidential candidate, Barack Obama, has vowed to impose Strickland’s interest rate cap nationally. This will mean that people will have fewer options making ends meet in tough times. If this bill should be passed, what then do they offer the people in return when life throws one of its little surprises? Before casting your vote, think about the dreadful consequences.