NY AG subpoenas private equity firms including Bain for tax dodging strategy (you can say it’s political, but only if you read the whole post)

by pdxblake

The NY Attorney General subpoenaed several private equity firms in July, including Bain Capital about their use of a loophole to lower the taxes paid on their management fee (distinct from their ‘performance fee’).  For a quick refresher on the management fee and performance fees, refer to a Business Insider post written shortly after Gawker published a load of leaked documents on Romney’s investments:

Private-equity firms, like other fund management firms, generally charge two kinds of fees on each fund:

• Performance-based fees, which pay the firm ~20% of any gains
• Management fees, which assess an annual ~2% fee on all invested capital

Both of these fees are standard professional fees, so they both should be taxed at ordinary income rates.

In one of the most outrageous loopholes in the tax code, however, the fund-management industry has bamboozled (or simply bribed) Congress into treating “performance-based” fees as capital gains rather than income. So, unlike lawyers, doctors, architects, mechanics, and hundreds of other service professionals, fund managers get the privilege of having their fees accrue tax-free in their funds.

The post–which I have to admit was rather prescient in light of the NY AG’s subpoenas–quotes a tax law professor who saw an illegal tax dodge in the Bain funds:

This trick involves treating not just “performance-based fees” but management fees as capital gains rather than ordinary income.

[…]

Bain also claimed capital gains treatment for its management fees. This allowed the funds (and Romney) to avoid paying ordinary income taxes on all of its fees, not just its performance fees.

How did Bain claim that its management fees were capital gains?

By “waiving” its management fees in some years in exchange for receiving a priority payment of “profit” in future years.

In other words, instead of taking a $20,000 cash payment for each $1 million under management in a particular year, Bain opted to take the $20,000 payment in a later year, as the first portion of any profit distributed from one of the fund’s investments.

The basic problem with the entire ‘carried interest’ loophole is that the money invested in the funds on which the performance fee is based is 1) not the investment managers; 2) not at risk of loss (at least for the investment manager); and 3) even if the performance fee did deserve capital gains treatment, it should have been taxed before it was used to generate a ‘capital gain’.

On point 3, if you make a capital gain by selling your house, then you bought your house with after-tax income (paying your mortgage, deducting from your income the amount of interest you paid on the mortgage).  When you sell it, you get to pay taxes on the gain you made at the capital gains tax rate (which for the moment is lower than on income) so that you are not paying taxes on the money you were already taxed on that you used to buy the house (the gain is the sale price – purchase price).

However, the ‘gain’ in the performance fee is just income.  There was no ‘capital’ that was invested to yield a profit, which is taxed as a capital gain (which again, for the moment, happens to be higher than the ordinary income tax rate).  Well, let me correct myself, there is capital, it is just not yours, you just manage it for other people.  So you have not invested your capital (money saved up, which you already paid taxes on), but you still want to treat the profit on it like a normal capital gain.  Hmm, interesting.

Returning back to the issue of the subpoena, trying to get capital gains tax treatment of management fees is even more egregious since the manager is not really putting the money (earlier period fee income) at risk of loss by granting a waiver and ‘investing’ it in the fund.  It is investing it in the funds with both 1) first priority from any future profit distributions; and 2) full knowledge of the investments in the fund,  knowledge of which ones are in black, and the power to sell the profitable investments to cash out the management fee in the future.

So, it shouldn’t be too surprising to see an investigation, and yes, you can bring on the “Schneiderman is doing this to help Obama win” argument.  You may be correct (I think it’s unlikely since Romney is relatively unconnected with Bain’s practice of trying to game the tax treatment of management fees, at least in the past 10+ years, or is he?).  However, it doesn’t win the argument about whether management fees should be taxed at the capital gains rate.