Private-equity shenanigans

For all but a few years since 1922, Congress has taxed capital gains at a lower rate than wages in the hope of encouraging people to invest more of their income. The preferential rate has also encouraged some Wall Street executives to structure their pay so that the Internal Revenue Service treats it like capital gains, not salary. Now New York Atty. Gen. Eric Schneiderman is exploring whether one of those maneuvers — used typically by private-equity firms — amounts to tax fraud. It’s a gray area legally, but the dispute highlights one of the problems that lawmakers should try to fix as part of a badly needed overhaul of the tax code.

Private-equity firms typically collect money from big-dollar investors, such as public pension funds, and then use it to make bets on companies they think are capable of dramatic growth — start-ups, for example, or companies in need of a turnaround. The bets are managed by a general partner, whose compensation typically consists of an annual fee and a 20% share of the investments’ profits. The fee is subject to ordinary income tax rates of up to 35%. But the 20% share, called “carried interest,” is considered a capital gain and taxed at a maximum rate of 15%.

That’s all legal. Schneiderman is examining whether five private-equity firms violated tax law by waiving their fees in exchange for an equal amount of compensation taken out of their investments’ profits. Such fee waivers, which apparently are widely used, convert ordinary income into capital gains. But while they enjoy the tax advantages of the capital-gains preference, they don’t yield any of the benefits to the economy or the public that the preference was intended to generate. They don’t increase the amount invested in American businesses or boost the supply of dollars available for entrepreneurs and growing companies.

Although some firms consider the fee waivers too legally suspect to pursue, the IRS has looked into the practice but has not ruled against it. And because one of the companies being probed is Bain Capital, the firm founded by Republican presidential nominee Mitt Romney, some critics of the investigation say Schneiderman, a Democrat, is just playing politics. (The trustee who manages Romney’s assets has said Romney’s Bain-related holdings have never used such waivers.) But a number of tax experts have argued over the years that the waivers violate the letter of federal law as well as the spirit of the tax code, so the five firms’ practices in this area deserve scrutiny.

The ultimate arbiter probably will be the federal courts, which may decide that the fee waivers — which provide the general partner a deferred but all-but-guaranteed income stream — meet the statutory definition of capital gains. Even so, the gamesmanship involved is deplorable. The surest deterrent would be to end the preference for capital gains, as President Reagan and Congress agreed to do in the Tax Reform Act of 1986, but that could have unwelcome effects on the availability of capital. If lawmakers aren’t willing to go that far, they should at least look for ways to limit the tax break to truly productive investments.