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The wrong loophole

Senators looking to restore tax cuts should keep their hands off private equity funds' capital gains.

May 15, 2007

SHOULD MANAGERS OF takeover firms be encouraged by the tax code to receive a share of the profits from a restructured company's eventual sale? The question might bore even accountants, but billions of dollars of profits and potential tax revenues are at stake. That's why the Senate Finance Committee is considering classifying the managers' payday as ordinary income, subject to tax rates as high as 35%, instead of as long-term capital gains, which are taxed at 15%. This time lawmakers are barking up the wrong loophole.

At issue are private equity funds that take over distressed or undervalued companies. If the acquisitions fail, the fund takes a big loss and maybe even liquidates. If they succeed, the fund can make a bundle selling off the companies. Proceeds are split between investors and fund managers, the latter of whom take a piece of potential profits in lieu of a full salary, and as a result pay the lower capital gains tax.

The Finance Committee is exploring whether to remove the capital gains option for executives at private equity firms and hedge funds, but it has offered no rationale as to why they shouldn't qualify when managers at venture capital firms and real estate investment trusts do. These entities operate in much the same way -- one or more executives act as the general partner, who negotiates deals and manages the investments for the overall fund. The partner's base compensation is an annual fee from the fund, usually 2% of its investments, but he or she typically receives 20% of any profits when acquired companies are sold.

Critics say taxing those proceeds as capital gains is an accounting fiction. General partners provide services, and their compensation should be taxed the same as an ordinary paycheck. But unlike typical employees, they are effectively plowing much of their potential salary back into their acquisitions. That's no different from those who start a business, take a reduced salary while building up clientele, then sell the company. The profits from that sale are rightly taxed as capital gains.

The larger question is whether to tax capital gains at a lower rate than other forms of income. One of the ideas is to encourage people to take risks on longer-term investments, freeing up cash for job-creating entrepreneurs. The effectiveness of this strategy is open to some debate, but the importance of the goal is not. Risk-taking and entrepreneurship are crucial to the health of the economy. If the tax code is going to be used to promote behavior, rather than just raising revenue, those are exactly the sort of values it should promote.

True, the lower rate also proved attractive to adventurous accountants. But the solution to that problem is a simpler tax code that defines clearly the behavior it's trying to encourage.

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