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
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