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The Tax Prophet Newsletter   Issue # 50 June, 2007

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In This Issue:
Introduction
History
How it Works
Senate Review
Conclusion


The Private Equity Tax Loophole

Introduction

If you thought the rich are treated differently, check out this loophole currently being exploited by the super-wealthy and their advisors: Hedge funds and private equity funds are investment pools available only to institutions and extraordinary rich individuals. These funds are taxed as partnerships, rather than as traditional "C" corporations.

This distinction allows fund managers to receive their compensation income (called a "carried interest"), usually 20% of the total profit, as long-term capital gains, taxed at 15% federal, rather than as compensation income for labor, which can be taxed as high as 35% federal.

The result: this loophole allows these elite financial workers to pay tax on their labor income (running into the millions and in some cases hundreds of million, per year) at 15% federal.

History

Private-equity firms pool their investors' money with a small portion (generally 2%) of their own and then secure independent financing from banks or other institutions to acquire entire companies, which they then restructure and eventually sell for a profit.

The sheer size of private-equity firms have permitted them to acquire major U.S. companies, including, Dunkin'Donuts, Chrysler and Toys R Us.

Although hedge funds also pool money from large investors, they primarily invest in securities (stocks and bonds), rather than purchasing and operating companies.


How it Works

A partnership is a flow-through entity, which means the partnership does not pay tax. In contrast, a C corporation is a separate tax-paying entity whose tax rate is 35% federal. Dividend distributions from the corporation to its shareholders are typically taxed at 15% federal, for a combined tax of 50% federal.

Contrast this to a partnership. There is no partnership-level tax and if the earnings constitute long-term capital gains, the federal tax rate is 15%. While this tax rate should apply to investors (since a direct investment is securities or other investment assets would produce the same result) by tweaking the partnership tax rules, those working for the fund as managers, also obtain a federal tax rate of 15% on their carried interest.

The upshot: All fund participants, including the advisors, are taxed at 15% federal, in contrast to shareholders of a corporation, who face an effective 50% federal rate on their distributed profits.


Senate Review

The Senate Finance Committee is studying whether fund managers' ability to pay capital-gains rates on their carried interest is proper. Fund managers are not true investors since they have little money at risk and, in substance, are performing a money management service.

Since the only risk attached to their management services is the possibility of losing their investors' money, the carried interest is essentially a performance fee, and performance fees are considered compensation income taxed at ordinary income rates.

Note: Taxing these carried interests as ordinary income would produce between $4 to $6 billion in additional tax revenue, according to Congressional aides studying the issue.


Conclusion

With trillions of dollars socked away in private equity and hedge funds, look for Congress to close the current carried interest loophole, by treating the fund manager's income as service income, subject to ordinary income tax rates.




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All contents copyright 2007 Robert L. Sommers, attorney-at-law. All rights reserved. This newsletter provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet is a registered trademark of Robert L. Sommers.