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Investigation Brings “Carried Interest” Into Spotlight

Steven Covelman |
September 5, 2012 | 4:37 p.m. PDT

Staff Reporter

courtesy Creative Commons
courtesy Creative Commons
Private-equity firms, including Republican presidential nominee Mitt Romney’s former employer, Bain Capital, have come under investigation by New York’s attorney general largely for their use of a tax practice known as “carried interest.”

"Carried interest" is when private-equity firms raise money from investors and combine it with loans. Then they acquire companies and sell them for a profit in a few years time.

These firms then collect management fees from investors, which typically equal about 2 percent of assets.  They also take a cut of the investment profits, otherwise known as “carried interest,” which averages approximately 20 percent.

Bloomberg explains how “carried interest” becomes controversial:

At issue in the New York investigation is that some firms convert the fees, which are taxed as ordinary income at rates as high as 35 percent, into stake in a fund whose carried nterest is taxed as capital gains at 15 percent [...]

   

By deferring the receipt of fees, buyout firms get a second benefit by deferring the tax. While the partners are well- positioned to know what investments may be winners, the waiver is irrevocable, meaning the fees disappear if the deals don’t generate profit.

According to Edward Kleinbard, a tax expert at the University of Southern California’s Gould School of Law, this is not an illegal practice.

“Firms like Bain are aggressive in their use of tax minimization strategies,” Kleinbard said. “Carried interest itself should be taxed as ordinary income, but to call it illegal is unfair.”

Kleinbard said that what comes into question most is the timing of the fee waivers.  

“If they did it a year in advance then it is probably okay,” Kleinbard said. “It is possible that Bain’s structures worked and it is possible that they did not, but in the end what it really comes down to is the facts.”

According to the New York Times, Bain’s financial statements show that at least $1 billion in fees were converted into investments that produced capital gains, which are taxed at a lower rate of 15 percent compared to the rate of 35 percent for ordinary income.

“The IRS has not devoted a lot of energy to this issue,” Kleinbard said.

The case against firms such as Bain, Apollo Global Management and TPG Capital was brought on by New York Attorney General Eric T. Schneiderman, a democrat with ties to the Obama administration.  

In all, at least twelve different private-equity firms are being investigated for how they reduced their taxes. 

 

Reach Staff Reporter Steven Covelman here.



 

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