Higher Tax on Buyout Firms Would Hit Hedge Fund Sales

By Ryan J. Donmoyer, May 27 2010 (Bloomberg) -- Private equity firms, trying to derail legislation that would boost taxes on their leaders' pay, are attacking a provision that would make it more costly for executives to sell their own management firms.

The provision, which would also affect operators of hedge funds, would make executives pay ordinary income tax rates on profits from selling a stake in their own management companies. Founders of other types of businesses would remain eligible to pay lower capital gains rates when they sell.

"This bill would make investment partnerships the only businesses in America whose owners would be ineligible for long-term capital-gains treatment" when they sell their stake in a firm, said Douglas Lowenstein, president of the Private Equity Council. The Washington trade group was founded by Blackstone Group LP, KKR & Co. and about a dozen other private- equity firms.

The provision is intended to stop executives at buyout, venture-capital and real-estate partnerships from circumventing the higher taxes on their pay imposed by the bill, said Matthew Beck, a House Ways and Means Committee spokesman. Otherwise, he said, fund managers would sell their stake, and pay the lower tax rate, just before receiving income subject to higher taxes.


Possible Vote Delay

A planned vote today in the U.S. House on a $145 billion jobs bill that contains the provision may be delayed over concerns by some Democrats over unrelated portions of the bill, lawmakers said.

The broader legislation would extend unemployment aid, subsidize local infrastructure programs and renew dozens of tax breaks for businesses and individuals. Congress is trying to complete work on the bill before taking a week-long Memorial Day recess.

The legislation would raise the tax on private-equity firm executives' share of profit, known as carried interest. That share often qualifies for capital-gains tax rates of 15 percent; the bill would eventually subject three-quarters of the income to ordinary tax rates of more than 40 percent.

Most hedge fund managers wouldn't be affected by that tax increase because they pursue short-term trading strategies that don't qualify for the capital-gains rate. As a result, hedge fund managers have largely stayed out of the debate over taxing carried interest, according to the Managed Funds Association, a Washington trade group for the industry.


Caught Unaware

The tax on sales of management companies is a separate issue. It would apply to the sale of any firms, including hedge funds, founded by financiers to manage funds that generate carried interest.

Michigan Representative David Camp, the top Republican on the Ways and Means Committee, said yesterday he wasn't aware the provision was in the bill and said it should have been subject to more scrutiny in congressional hearings. Camp said he will oppose the bill.

"The legislation should pick up carried-interest income, not the value of the business they've created," said Pamela Olson, a former top tax policy official in President George W. Bush's administration. "That's just a wildly wrong answer." She represents Los Angeles-based Oaktree Capital Management LLC, an investment firm that may be affected by the carried- interest legislation.

Victor Fleischer, a University of Colorado law professor, said the provision is "absolutely necessary" to stop investment funds from avoiding the new tax on carried interest. Fleischer's academic paper on carried interest in 2007 helped shape the legislation.


Blackstone Founders

"Think about Blackstone," Fleischer said. "When Stephen Schwarzman and Pete Peterson sell their chunks of Blackstone and get capital-gains treatment, really what they're doing is monetizing their future stream of carried interest." Schwarzman and Peterson are the co-founders of Blackstone, and Schwarzman remains its chairman.

"It makes sense to target the folks who have the most amount of money flowing through the partnerships," Fleischer said. "Fund managers are going to be treated worse than a restaurant founder, but I'm OK with that."

Blackstone spokesman Peter Rose said, "To single out Stephen Schwarzman for a punitive tax may cause populist pleasure, but makes for lousy tax policy." He said such a rule would punish "not only Mr. Schwarzman but the tens of millions of Americans, including the proverbial restaurant owner, who have started businesses in investment partnerships."