IRS warned, but did not act on tax strategy for private equity

WASHINGTON Mon Sep 3, 2012 6:27pm EDT

WASHINGTON (Reuters) - U.S. tax authorities took no formal action after launching a probe five years ago of tax strategies used by private equity managers at firms such as Bain Capital LLC, leaving a legal gray area that is now being examined by New York's attorney general.

In a move focusing more scrutiny on private equity at a politically turbulent time, New York Attorney General Eric Schneiderman has subpoenaed documents from at least a dozen firms about how they reduce their managers' tax bills, a source familiar with the matter told Reuters.

Among firms subpoenaed, in addition to Bain, were KKR & Co LP, TPG Capital LP, Apollo Global Management LLC and Silver Lake Partners LP, a source told Reuters.

Schneiderman is investigating "management fee waivers," in which private equity managers convert portions of their pay into investment income, reducing the tax rate on that pay to 15 percent. That is the same rate they pay for "carried interest," a related form of investment gain that the managers get from the business of buying, managing and selling companies.

The tax status of carried interest has drawn fire for years from Democrats in the U.S. Congress who argue the gains should be taxed as ordinary income. The private equity industry and their allies have blocked such a change, arguing that carried interest carries risks and deserves investment tax treatment.

A spokesman for the U.S. Internal Revenue Service said on Monday the agency had no immediate comment on the issue.

The private equity industry's role in the economy and its tax status have become political issues in the 2012 presidential campaign because Bain Capital was co-founded and once led by Mitt Romney, the Republican candidate hoping to unseat President Barack Obama in the November 6 election.

Romney's campaign said he did not take part in the fee-waiver program. Bain declined to comment.

The IRS said in November 2007 it was studying tax techniques used by alternative investment firms, including private equity.

"The service never said anything after that," said Francois Hechinger, a partner in the private equity tax practice at accounting firm BDO in California. "This is becoming a controversial issue."

It is unknown if the IRS audited private equity funds to investigate management compensation. It is also unclear why the IRS took no public action.

A tax lawyer who was at the IRS in 2007 said the firms' pay structures are complex, posing a challenge for IRS auditors.

TWO AND TWENTY

The tax issue centers on the disparate treatment given under U.S. law to income from wages, taxed at a top rate of 35 percent, and that applied to investments, taxed at 15 percent.

Private equity managers typically get a "2-and-20" compensation package. This consists of a 2 percent management fee, taxed as ordinary income, and a 20 percent share of fund profits, taxed as capital gains at 15 percent.

The 2 percent fee is guaranteed income that defrays some of the risk associated with investing. But managers may waive the fee and convert it to income that benefits from the lower tax rate.

Experts such as Hechinger defend the fee-waiver strategy because of the increased risk to which the income is subject. "You're taking a risk - there is no certainty you're going to have income in the life of the fund," Hechinger said.

Others say it is not so clear. Critics argue that fee waiver is a tax loophole.

"The IRS hasn't issued any notice (about the 2007 inquiry) and it is kind of a puzzle to me why they haven't," said Victor Fleischer, a law professor at the University of Colorado, among those who first highlighted the tax technique. "It has been this open secret in the private equity world."

DEMOCRATS TRIED PREVIOUSLY

The timing of the probe and Schneiderman's credentials as a Democrat could raise eyebrows in political circles.

Romney has not said how he would handle the issue, but Ryan voted several times against the Democrats' bid to change the tax treatment in the House.

Fleischer, a critic of the tax strategy, said a 2006 Romney financial disclosure shows more than $1 million in income from a Bain fund that has received converted management fees.

On the broader issue of carried interest, Democrats have been trying for years to close what they see as a tax break. They came closest in 2010 when they controlled the House of Representatives, the Senate and the White House.

Still, they failed, in large part because some Senate Democrats tried to carve out exceptions for certain industries.

After the upcoming elections, wide-ranging tax code reform is seen by some on Capitol Hill as a possibility in 2013.

The private equity industry appears likely to feature in the debate.

(This story has been refiled to change partners to partner in paragraph 10)

(Additional reporting by Karen Freifeld and Greg Roumeliotis; Editing by Kevin Drawbaugh and Dan Grebler)