The Obama administration has been fighting to eliminate a “tax loophole” that benefits private equity executives by taxing their profits from investments in companies (“carried interest”) by the capital gains rate of 20 percent instead of the regular income rate of nearly 40 percent. Congress has kept this from happening, but the decision in a recent case by the Federal Court of Appeals for the First Circuit in Massachusetts might put enough power in the hands of the Treasury Department and the Internal Revenue Service to win the fight.
The arguments on both sides of the tax break are pretty self-explanatory. Private equity players, although not all, argue that the tax break is necessary because it provides a valuable incentive to invest, which in turn creates jobs and allows for some healthy risk-taking. Opponents are averse to letting wealthy investors pay lower taxes than workers who pay the regular income rate, and the government estimates that taxing private equity investors at the latter rate would raise billions of dollars over the next decade.
Sun Capital Partners, a private equity firm that turns underperforming companies around and sells them for a profit, sued the pension fund of Scott Brass, a bankrupt brass and copper manufacturer, seeking a declaratory judgment with respect to $4.15 million in pension obligations. Sun Capital had to assert that its funds were merely “passive investors” with indirect control of Scott Brass, and not engaged in the “trade or business” of operating it. But the First Circuit ruled against Sun Capital, holding that it “sufficiently operated, managed, and was advantaged by its relationship with [Scott Brass].”
This could have serious implications for private equity investors. To qualify for the lower, capital gains rate, the tax code provides that private equity investors cannot be engaged in a “trade or business” operating their companies. So if Sun Capital’s ordinary private equity activities are accurately characterized as “trades or businesses” under the similarly-termed pension code, then private equity funds may no longer be legally eligible for the lower, capital gains tax rate.
The aftermath has seen a lot of invigorating discussion in the private equity community about what sort of impact the decision will actually have. According to The New York Times, some analysts suggest that a shift to the regular income rate is inevitable, while others offer that private equity can avoid that outcome by making their investments more “passive.”
However, the invigoration might really just be speculation. There is doubt that the government is capable of confronting litigation by powerful private equity firms at the moment. And Steve Judge, president and CEO of the Private Equity Growth Capital Council, believes the decision will have zero effect on the application of tax law, since 1) the First Circuit itself acknowledged that its decision does not apply to tax law, and 2) such changes to the tax law require “statutory changes” that cannot be achieved through mere administrative guidance.