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Lawmakers supporting the bill on Capitol Hill to raise taxes on private equity firms going public claim that it’s a basic matter of tax fairness. The bill’s sponsors, Democratic Senator Max Baucus and Republican Senator Chuck Grassley, have argued that private equity companies should not be allowed to access the public capital markets without having to pay the 35% corporate income tax. But the notion that private equity firms enjoy an unfair tax advantage may actually depend on a misunderstanding of how they make money and how they pay taxes.
Most private equity firms are organized as partnerships so that they can take advantage of a provision of the tax law that exempts certain kinds of partnerships from the corporate tax. Like most parts of the tax code, these provisions are written in a convoluted loophole-within-loophole style way that would have string theory physicists scratching their heads. So don’t get too worried about the details.*
One of the reasons the partnership structure is so important for private equity firms is that they make so much of their money from owning and selling operating companies—like, say, Chrysler—that are already subject to corporate taxation. If the private equity partnerships were taxed at the corporate rate, they’d effectively be taxed twice—once at the op-co level, and once at the partnership level. To make things worse, they’d really be taxes three times, since distributions to partners are subject to capital gains taxes. It seems a bit extreme to tax the same revenue stream over and over again.
Today’s Wall Street Journal editorial page, however, says that this is exactly what the Blackstone Bill would do. “Under the Baucus-Grassley proposal, Blackstone’s investment income would be taxed first at a 35% corporate tax rate on, say, American Widget Company when it earned the profits; taxed again when those profits are passed on to Blackstone at another 35% corporate income tax rate; and then taxed a third time at a 15% capital gains tax when Blackstone distributes its earnings to partners and shareholders,” the Journal says.
The Blackstone Tax [Wall Street Journal]
* If you must know, one provision says all partnerships get taxed with the corporate rate. Another provision creates a list of about fifteen different types of entities that are exempt from this treatment. Private equity partnerships fall under the exception for entities deriving income from “passive type income”—which is income from capital gains. This means that the law treats them as “pass-through” partnerships, so that the taxes don’t hit the partnerships themselves but only the owners of the partnerships. Because of this the managers of the partnerships typically pay capital gains taxes, rather than ordinary income taxes, on the profits of the firm.