Private Inequity: How a Powerful Industry Conquered the Tax System

 

From NYT: Private Inequity: How a Powerful Industry Conquered the Tax System There were two weeks left in the Trump administration when the Treasury Department handed down a set of rules governing an obscure corner of the tax code.

Overseen by a senior Treasury official whose previous job involved helping the wealthy avoid taxes, the new regulations represented a major victory for private equity firms. They ensured that executives in the $4.5 trillion industry, whose leaders often measure their yearly pay in eight or nine figures, could avoid paying hundreds of millions in taxes.

The rules were approved on Jan. 5, the day before the riot at the U.S. Capitol. Hardly anyone noticed.

The Trump administration’s farewell gift to the buyout industry was part of a pattern that has spanned Republican and Democratic presidencies and Congresses: Private equity has conquered the American tax system.

The industry has perfected sleight-of-hand tax-avoidance strategies so aggressive that at least three private equity officials have alerted the IRS to potentially illegal tactics, according to people with direct knowledge of the claims and documents reviewed by The New York Times. The previously unreported whistleblower claims involved tax dodges at dozens of private equity firms.

But the IRS, its staff hollowed out after years of budget cuts, has thrown up its hands when it comes to policing the politically powerful industry.

While intensive examinations of large multinational companies are common, the IRS rarely conducts detailed audits of private equity firms, according to current and former agency officials.

Such audits are “almost nonexistent,” said Michael Desmond, who stepped down this year as the IRS’s chief counsel. The agency “just doesn’t have the resources and expertise.”

One reason they rarely face audits is that private equity firms have deployed vast webs of partnerships to collect their profits. Partnerships do not owe income taxes. Instead, they pass those obligations on to their partners, who can number in the thousands at a large private equity firm. That makes the structures notoriously complicated for auditors to untangle.

Increasingly, the agency doesn’t bother. People earning less than $25,000 are at least three times more likely to be audited than partnerships, whose income flows overwhelmingly to the richest 1% of Americans.

The consequences of that imbalance are enormous.

By one recent estimate, the United States loses $75 billion a year from investors in partnerships failing to report their income accurately — at least some of which would probably be recovered if the IRS conducted more audits. That’s enough to roughly double annual federal spending on education.

It is also a dramatic understatement of the true cost. It doesn’t include the ever-changing array of maneuvers — often skating the edge of the law — that private equity firms have devised to help their managers avoid income taxes on the roughly $120 billion the industry pays its executives each year.

Private equity’s ability to vanquish the IRS, Treasury and Congress goes a long way toward explaining the deep inequities in the U.S. tax system. When it comes to bankrolling the federal government, the richest of America’s rich — many of them hailing from the private equity industry — play by an entirely different set of rules than everyone else.

The result is that men like Blackstone Group’s chief executive, Stephen A. Schwarzman, who earned more than $610 million last year, can pay federal taxes at rates similar to the average American.

Lawmakers have periodically tried to force private equity to pay more, and the Biden administration has proposed a series of reforms, including enlarging the IRS’s enforcement budget and closing loopholes. The push for reform gained new momentum after ProPublica’s recent revelation that some of America’s richest men paid little or no federal taxes.

The private equity industry, which has a fleet of almost 200 lobbyists and has doled out nearly $600 million in campaign contributions over the last decade, has repeatedly derailed past efforts to increase its tax burden.

The IRS commissioner, Charles Rettig, who was appointed by President Donald Trump, declined to be interviewed for this article. But in testimony before the Senate Finance Committee on Tuesday, he acknowledged that the agency wasn’t doing enough to scrutinize partnerships.

“If you’re a wealthy cheat in a partnership, your odds of getting audited are slightly higher than your odds of getting hit by a meteorite,” Sen. Ron Wyden, the committee’s chairman, told Rettig at the hearing. “For the sake of fairness and for the sake of the budget, it makes a lot more sense to go after cheating by the big guys than focus on working people.”

Yet that is not what the IRS has done.

A Lucrative Distinction

Private equity firms typically borrow money to buy companies that they see as ripe for turnarounds. Then they cut costs and resell what’s left, often laden with debt. The industry has owned brand-name companies across nearly every industry. Today its prime assets include Staples, Petco, WebMD and Taylor Swift’s back music catalog.

The industry makes money in two main ways. Firms typically charge their investors a management fee of 2% of their assets. And they keep 20% of future profits that their investments generate.

That slice of future profits is known as “carried interest.” The term dates at least to the Renaissance. Italian ship captains were compensated in part with an interest in whatever profits were realized on the cargo they carried.

The IRS has long allowed the industry to treat the money it makes from carried interests as capital gains, rather than as ordinary income.

For private equity, it is a lucrative distinction. The federal long-term capital gains tax rate is currently 20%. The top federal income tax rate is 37%.

The loophole is expensive. Victor Fleischer, a University of California, Irvine, law professor, expects it will cost the federal government $130 billion over the next decade.

Back in 2006, Fleischer published an influential article highlighting the inequity of the tax treatment. It prompted lawmakers from both parties to try to close the so-called carried interest loophole. The on-again, off-again campaign has continued ever since.

Whenever legislation gathers momentum, the private equity industry — joined by real estate, venture capital and other sectors that rely on partnerships — has pumped up campaign contributions and dispatched top executives to Capitol Hill. One bill after another has died, generally without a vote.

An Unexpected Email

One day in 2011, Gregg Polsky, then a professor of tax law at the University of North Carolina, received an out-of-the-blue email. It was from a lawyer for a former private equity executive. The executive had filed a whistleblower claim with the IRS alleging that their old firm was using illegal tactics to avoid taxes.

The whistleblower wanted Polsky’s advice.

Polsky had previously served as the IRS’s “professor in residence,” and in that role he had developed an expertise in how private equity firms’ vast profits were taxed. Back in academia, he had published a research paper detailing a little-known but pervasive industry tax-dodging technique.

Private equity firms already enjoyed bargain-basement tax rates on their carried interest. Now, Polsky wrote, they had devised a way to get the same low rate applied to their 2% management fees.

The maneuver had been sketched out a few years earlier by the Silicon Valley law firm Wilson Sonsini Goodrich & Rosati, in a 48-page presentation filled with schematic diagrams and language that only a finance executive could love. “Objective,” one slide read. “Change Management Fee economics to achieve Carried Interest tax treatment, without reducing GP cash flow or adding unacceptable risk.”

In a nutshell, private equity firms and other partnerships could waive a portion of their 2% management fees and instead receive a greater share of future investment profits. It was a bit of paper shuffling that radically lowered their tax bills without reducing their income.

The technique had a name: “fee waiver.”

Soon, the biggest private equity firms, including Kohlberg Kravis Roberts, Apollo Global Management and TPG Capital, were embedding fee-waiver arrangements into their partnership agreements. Some stopped using fee waivers when they became publicly traded companies, but the tax-avoiding device remains in wide use in the industry.

“It’s like laundering your fees into capital gains,” said Polsky, whose paper argued that the IRS could use long-standing provisions of the tax code to crack down on fee waivers. “They put magic words into a document to turn ordinary income into capital gains. They have zero economic substance, and they get away with it.”

That was why the whistleblower was getting in touch.

The Three Whistleblowers

Polsky began talking with the former private equity executive, whose IRS claim accused three firms of illegally using fee waivers. (Whistleblowers receive a portion of whatever the IRS recovers as a result of their claims.)

Before long, Polsky heard from a second whistleblower. And then a third.

The whistleblowers — whose previously undisclosed claims are not public but were reviewed by The Times — had independently obtained dozens of private equity and venture capital firms’ partnership agreements from former colleagues in the industry, laying out the fee waivers in great detail.

The arrangements all had the same basic structure. Say a private equity manager was set to receive a $1 million management fee, which would be taxed as ordinary income, now at a 37% rate. Under the fee waiver, the manager would instead agree to collect $1 million as a share of future profits, which he would claim was a capital gain subject to the 20% tax. He’d still receive the same amount of money, but he’d save $170,000 in taxes.

The whistleblowers, two of whom hired Polsky to advise them, argued that this was a flagrant tax dodge. The whole idea behind the managers’ compensation being taxed at the capital gains rate was that they involved significant risk; these involved almost none.

Many of the arrangements even permitted partners to receive their waived fees if their private equity fund lost money.

That was the case at Bain Capital, whose tactics a whistleblower brought to the attention of the IRS in 2012. That year, Bain’s former head Mitt Romney was the Republican nominee for president.

Another whistleblower’s claim described fee waivers used at Apollo — one of the world’s largest buyout firms, with $89 billion in private equity assets — as being “abusive” and a “thinly disguised way of paying the management company its quarterly paycheck.”

Apollo said in a statement that the company stopped using fee waivers in 2012 and is “not aware of any IRS inquiries involving the firm’s use of fee waivers.”

Prompted at least in part by the whistleblower claims, the IRS began examining fee waivers at a number of private equity firms, according to agency documents and lawyers who represented the firms.

This would be the last time the IRS seriously examined private equity, and it would not amount to much.

Codifying a Tax Dodge

Early in his first term, President Barack Obama floated the idea of cracking down on carried interest.

Private equity firms mobilized. Blackstone’s lobbying spending increased by nearly a third that year, to $8.5 million. (Matt Anderson, a Blackstone spokesman, said the company’s senior executives “are among the largest individual taxpayers in the country.” He wouldn’t disclose Schwarzman’s tax rate.)

Lawmakers got cold feet. The initiative fizzled.

In 2015, the Obama administration took a more modest approach. The Treasury Department issued regulations that barred certain types of especially aggressive fee waivers.

But by spelling that out, the new rules codified the legitimacy of fee waivers in general, which until that point many experts had viewed as abusive on their face.

To the frustration of some IRS officials, private equity firms now had a road map for how to construct the arrangements without running afoul of the government. (The agency continued to review fee waivers at some firms where whistleblowers had raised concerns.)

The Treasury secretary at the time, Jacob Lew, joined a private equity firm after leaving office. So did his predecessor in the Obama administration, Timothy F. Geithner.

Inside the IRS — which lost about one-third of its agents and officers from 2008 to 2018 — many viewed private equity’s webs of interlocking partnerships as designed to befuddle auditors and dodge taxes.

One IRS agent complained that “income is pushed down so many tiers, you are never able to find out where the real problems or duplication of deductions exist,” according to a U.S. Government Accountability Office investigation of partnerships in 2014. Another agent said the purpose of large partnerships seemed to be making “it difficult to identify income sources and tax shelters.”

The Times reviewed 10 years of annual reports filed by the five largest publicly traded private equity firms. They contained no trace of the firms ever having to pay the IRS extra money, and they referred to only minor audits that they said were unlikely to affect their finances.

Current and former IRS officials said in interviews that such audits generally involved issues like firms’ accounting for travel costs, rather than major reckonings over their taxable profits. The officials said they were unaware of any recent significant audits of private equity firms.

No Money Owed

For a while, it looked as if there would be an exception to this general rule: the IRS’s reviews of the fee waivers spurred by the whistleblower claims. But it soon became clear that the effort lacked teeth.

The agency did not audit most of the 32 private equity firms that were the subject of one whistleblower’s claims, according to an IRS document reviewed by The Times. So far, the agency appears to have recovered only small amounts in back taxes, including a total of less than $1 million from two firms, according to two people familiar with the audits. (A handful of audits are ongoing.)

In 2014, the IRS began auditing the fee waivers used by Thoma Bravo, a large San Francisco private equity firm that owns companies like McAfee and JD Power, according to records reviewed by The Times. One of the whistleblowers had asserted that Thoma Bravo managers were avoiding taxes by claiming their waived fee income was capital gains, even though it entailed negligible risk.

Agents tried to impose back taxes and penalties on Thoma Bravo, the records show. The company appealed. An internal IRS review panel sided with Thoma Bravo. The challenge was over. “We are not proposing any adjustments” to the company’s tax returns, an IRS official in the agency’s Chicago office informed Thoma Bravo in a July 2018 letter, reviewed by The Times.

A Thoma Bravo spokesman declined to comment.

Kat Gregor, a tax lawyer at the law firm Ropes & Gray, said the IRS had challenged fee waivers used by four of her clients, whom she wouldn’t identify. The auditors struck her as untrained in the thicket of tax laws governing partnerships.

“It’s the equivalent of picking someone who was used to conducting an interview in English and tell them to go do it in Spanish,” Gregor said.

The audits of her clients wrapped up in late 2019. None owed any money.

The Mnuchin Compromise

As a presidential candidate, Trump vowed to “eliminate the carried interest deduction, well-known deduction, and other special-interest loopholes that have been so good for Wall Street investors, and for people like me, but unfair to American workers.”

But his administration, stocked with veterans of the private equity and hedge fund worlds, retreated from the issue.

In 2017, as Republican lawmakers rushed through a sweeping package of tax cuts, Democrats tried to insert language that would recoup some revenue by collecting more from private equity. They failed.

“Private equity weighs in so consistently and so aggressively and is always saying that Western civilization is going to end if they have to pay taxes annually at ordinary income rates,” said Sen. Ron Wyden, D-Ore.

While White House officials claimed they wanted to close the loophole, congressional Republicans resisted. Instead, they embraced a much milder measure: requiring private equity officials to hold their investments for at least three years before reaping preferential tax treatment on their carried interests. Steven Mnuchin, the Treasury secretary, who had previously run an investment partnership, signed off.

“We were trying to strike a balance between protecting the tax base with making sure that we didn’t inadvertently penalize legitimate business and investment activity,” said George Callas, who was senior tax counsel to Paul Ryan, the House speaker.

It was a token gesture for an industry that typically holds investments for more than five years, according to McKinsey. The measure, part of a $1.5 trillion package of tax cuts, was projected to generate $1 billion in revenue over a decade.

Private equity cheered. One of the industry’s top lobbyists credited Mnuchin, hailing him as “an all-star.”

Fleischer, who a decade earlier had raised alarms about carried interest, said the measure “was structured by industry to appear to do something while affecting as few as possible.”

Months later, Callas joined the law and lobbying firm Steptoe & Johnson. The private equity giant Carlyle is one of his biggest clients.

‘The Government Caved’

It took the Treasury Department more than two years to propose rules spelling out the fine print of the 2017 law. The Treasury’s suggested language was strict. One proposal would have empowered IRS auditors to more closely examine internal transactions that private equity firms might use to get around the law’s three-year holding period.

The industry, so happy with the tepid 2017 law, was up in arms over the tough rules the Treasury’s staff was now proposing. In a letter in October 2020, the American Investment Council, led by Drew Maloney, a former aide to Mnuchin, noted how private equity had invested in hundreds of companies during the coronavirus pandemic and said the Treasury’s overzealous approach would harm the industry.

The rules were the responsibility of Treasury’s top tax official, David Kautter. He previously was the national tax director at EY, formerly Ernst & Young, when the firm was marketing illegal tax shelters that led to a federal criminal investigation and a $123 million settlement. (Kautter has denied being involved with selling the shelters but has expressed regret about not speaking up about them.)

On his watch at Treasury, the rules under development began getting softer, including when it came to the three-year holding period.

In December, a handful of Treasury officials working on the regulations told Kautter that the rules were not ready. Kautter overruled his colleagues and pushed to get them done before Trump and Mnuchin left office, according to two people familiar with the process.

On Jan. 5, the Treasury Department unveiled the final version of the regulations. Some of the toughest provisions had vanished. Among those was the one that would have allowed the IRS to scrutinize transactions between different entities controlled by the same firm. The result was that it became much easier to maneuver around the three-year holding period.

“The government caved,” said Monte Jackel, a former IRS attorney who worked on the original version of the proposed regulations.

Mnuchin, back in the private sector, is starting an investment fund that could benefit from his department’s weaker rules.

A Charmed March

Even during the pandemic, the charmed march of private equity continued.

The top five publicly traded firms reported net profits last year of $8.6 billion. They paid their executives $8.3 billion. In addition to Schwarzman’s $610 million, the co-founders of KKR each made about $90 million, and Apollo’s Leon Black received $211 million, according to Equilar, an executive compensation consulting firm.

The industry’s lawyers have largely decoded the 2017 law and discovered new ways for their clients to avoid taxes.

The law firm Kirkland & Ellis, which represented Thoma Bravo as it successfully fought the IRS, is now advising clients on techniques to circumvent the three-year holding period.

The most popular is known as a “carry waiver.” It enables private equity managers to hold their carried interests for less than three years without paying higher tax rates. The technique is complicated, but it involves temporarily moving money into other investment vehicles. That provides the industry with greater flexibility to buy and sell things whenever it wants, without triggering a higher tax rate.

Private equity firms don’t broadcast this. But there are clues. In a recent presentation to a Pennsylvania retirement system by Hellman & Friedman, the California private equity giant included a string of disclaimers in small font. The last one flagged the firm’s use of carry waivers.

The Biden administration is negotiating its tax overhaul agenda with Republicans, who have aired advertisements attacking the proposal to increase the IRS’s budget. The White House is already backing down from some of its most ambitious proposals.

Even if the agency’s budget were significantly expanded, veterans of the IRS doubt it would make much difference when it comes to scrutinizing complex partnerships.

“If the IRS started staffing up now, it would take them at least a decade to catch up,” Jackel said. “They don’t have enough IRS agents with enough knowledge to know what they are looking at. They are so grossly overmatched it’s not funny.”