Private Equity Tax Hikes

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					Private Equity Tax Hikes:
The Stealth Attack on State Pension Funds
Ryan Ellis American Shareholders Association www.americanshareholders.org

Many in Congress Want to Raise Taxes on Investment Partnerships
• H.R. 2834 (carried interest), S. 1624 (publiclytraded partnerships) are the stand-alone examples, but this tax hike is a “pay-for” on many other bills • Typically, these partnerships involve a managing general partner who invests funds, and limited partners who provide funds. The bills in question are targeted at the managing partner, but as we’ll see the incidence cannot be contained there

How Do Investment Partnerships Work?
• Let’s say five friends decide they want to start an investment club. Andy has no money, but is really good at investing. His four friends—Bill, Carol, David, and Earl—are each willing to kick in $1000 apiece, for a total investment pool of $4000 • Andy strikes a deal with them—he gets to keep half of whatever the $4000 nets in income • Andy is a good investor and earns $1600 the first year. He keeps $800, and the remaining $800 is split equally among the four investors

How Do Investment Partnerships Work?
• Basically, this is how investment partnerships work • Andy is the “managing general partner.” He doesn’t contribute in any money. Rather, he invests the money and keeps some of the investment return as his compensation (“the carry”) • Bill, Carol, David, and Earl are the “limited partners.” They each give Andy $1000 to invest, and hope that he can get them a return on their investment

Andy Is the Tax Hike Victim—At First
• Congress wants to raise the tax rate on Andy, the managing partner. Under current tax rules, he pays a 15% tax rate on long-term capital gains and qualified dividends earned by the partnership to which he is entitled—the same tax rate as anyone pays on this type of income • Congress would like Andy to have to pay a tax rate of 35% now, and potentially higher than 40% in the future

What About The Other Four Partners?
• The limited partners who put up the money and don’t invest (Bill, Carol, David, and Earl) also pay a 15% capital gains and dividends tax rate. That would not change under these proposals • Of course, in the real world these limited partners are often pension funds, charitable trusts, and foundations. Many of these are taxexempt, so much of the limited partner investment returns are untaxed

What About The Other Four Partners?
• According to the Private Equity Council, the top 20 government employee pension funds invest about 6% of their assets in these investment partnerships. CALPERS, the Teacher Retirement System of Texas, et al play the part of Bill, Carol, David, and Earl. These pension funds represent 10.5 million workers and retirees and have $111 billion invested in private equity • The top 20 corporate pension funds also invest about 6% of their assets in private equity. They represent 3.8 million workers and retirees and have $44 billion invested in private equity

If You Raise Taxes on Andy, He’ll Renegotiate with Bill, Carol, David, and Earl
• Let’s go back to our example of the five friends. If Congress tells Andy that they’ll be taxing his investment share at 35% instead of 15%, do you think he’s going to passively take it? Or will he renegotiate his deal with his four partners? • In order to make himself whole and get the same after-tax income, he’ll demand getting two-thirds of the investment return, not half • Instead of splitting up the other half of the investment return, Bill, Carol, David and Earl will be left divvying up a third of it instead

If You Raise Taxes on Andy, He’ll Renegotiate with Bill, Carol, David, and Earl
• Congress, in seeking to “punish” Andy for being successful, actually has only served to impoverish Bill, Carol, David, and Earl • Remember that in the real world, these four limited partners are actually state employee pension funds, corporate pensions funds, and charitable foundations • Therefore, raising taxes on private equity managers has the net effect of stealing from pension funds

What About Fairness?
• The most common reason policymakers give for raising Andy’s taxes is that it’s not “fair.” If Andy has a secretary, she almost certainly has a higher tax rate than Andy does (15% on cap gains and dividends) • This ignores the fact that Andy’s income is, in fact, capital gains and dividends. You wouldn’t expect a fish to bark, so why would you expect capital gains and dividends for Andy to be taxed differently than for you or me? Our tax system taxes income based on its nature, not its recipient • Andy also wouldn’t have gotten that income unless he was good at his job. What’s fair is treating Andy the same way any other taxpayer with this type of income is treated—which includes most everyone in this room

The Bottom Line for State Governments
• We mentioned earlier that state employee pension funds have $111 billion invested in private equity funds • How much of that money are you willing to give up in your state so that Congress can attach a “pay-for” to a tax bill? • Make no mistake about it—Congress raising taxes on private equity means you’ll have to find a way to make your state employee pension plans whole. It’s inescapable.

Where to Learn More
www.americanshareholders.org
www.privateequitycouncil.org http://cantor.house.gov/cfair/


				
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