April 7, 2014
Interviewed by: David Snow
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Deductibles in Danger

A push to address income inequality is causing U.S. policymakers to look at eliminating tax deductions as a way to get wealthy taxpayers and corporations to pay more in taxes. If enacted, key tax-policy ideas would affect private equity in a big way.

A push to address income inequality is causing U.S. policymakers to look at eliminating tax deductions as a way to get wealthy taxpayers and corporations to pay more in taxes. If enacted, key tax-policy ideas would affect private equity in a big way.

Deductibles in Danger
Taxes and Private Equity

David Snow, Privcap:
Today, we’re joined by Adam Weinstein of New Mountain Capital and Rick Bailine of RSM. Gentlemen, welcome to Privcap. Thanks for being here.

We’re talking about taxes and private equity, an important topic, but I’d like to talk about some broader political forces in the U.S. that might affect taxes and private equity.

One key driver in politics today is addressing income and equality. That’s a huge priority for the Democrats, in particular. I’d like to talk about how that might affect taxes and private equity. Rick, can you set the stage and talk about addressing inequity and how this might have tax implications?

Rick Bailine, RSM:
Sure, David. As you know, one big topic that has come to the national fore in the last three or four years is this notion of income and equality. It’s not just a lot of rhetoric. Max Baucus, chairman of the Senate Finance Committee, has been confirmed to be our next ambassador to China. His replacement, Senator Wyden, has already made a statement that he believes we need comprehensive reform of the internal revenue code and that one significant target that any comprehensive tax reform should address is this notion of income inequality. That simply means there is certainly a belief that we have a few people earning a lot of money and a lot of people not earning as much money.

Certainly, if you’re looking at addressing income equality, upper- income folks—and that includes the vast majority in private equity—are going to be seeing a situation where Congress is looking at whether they earn too much and need to pay more taxes. A significant portion of any income shift to address income inequality will affect the owners of private equity and their incomes.

Snow: Adam, I want to talk about specific policy ideas, but is that a trend your firm is watching carefully? Or at least you are, as someone who oversees the finances of the firm?

Adam Weinstein, New Mountain Capital:
Yes. I would say it a bit differently, in that I think what Washington has discussed and what’s on the table today is less about stated rates being at higher places, where they have spoken about that in the past. That was a big part of the fight in the 2010 extension of the Bush tax cuts and the 2012 rolloff for higher income folks. Now, the focus is on not changing overall rates, but changing overall policy as it surrounds all the different deductions and different ways people get around paying a full 39.6% (in the case of highest tax rates).

This argument was always there, but it was one of a multitude of arguments. It has now shifted more to where I just want everyone to pay his or her 39.6% tax. That means if you’re in the energy business and you get all these deductions for different things, I’d like to see those go away at a certain income level. If you are in the private equity or hedge fund business, I’d like to see carried interest be paid at a 39.6% rate. If you are making over a certain amount, I’d like to see that you don’t get mortgage interest deductions and other itemized deductions at the individual level.

It’s a move because people don’t want to return to 1981, where the highest tax rate is stated at 79% or whatever it was. People want to see the lower rates, but actually ensure people are paying there and that’s going to affect the private equity industry.

It’s effectively what you were saying, but in a different way that you’re seeing it, being looked at as just wanting everyone to pay what the contractual law rate is with the government.

Bailine: You’ve defined the debate quite well. When I said they’re going to pay more taxes, I would agree with you. It is not likely to be a situation where they’re going to increase the rates. It’s going to be a base broadening, where deductions will tend to go away.

I’ll give you a perfect illustration: if you’re paying 35% rate today and they lower your rate to 25% tomorrow, but you end up paying the same amount of tax, they really haven’t done anything for the people who are getting the rate reduction. But they do that by removing deductions—that’s how they make it neutral. They lower the rate and they take away deductions to broaden the base.

That will have a significant impact on private equity because, typically, private equity firms have portfolio companies, which are C corporations. Typically, the private equity entity itself is a partnership. Because it’s doing business as a partnership and not a corporation, it may not benefit from the rate reduction, but it still may be subject to the loss of deductions.

Snow: Generally, people in private equity and in finance and, in fact, high net-­‐worth individuals, have a disproportionate amount of their income coming from investment sources. What are some ideas around broadening the base or at least moving that to investment sources? How might that affect private equity?

Bailine: As you said, there are a lot of capital gains in private equity and, in virtually all high networth individuals, that would be the case. One thing on Senator Wyden’s list of changes is he would like to limit the application of capital gains. Now, he has given no specifics on what he means by “limit capital gains,” but the way Congress has been approaching this issue in the past, it might be something as basic as: if your adjusted gross income is over “x” dollars (and “x” dollars may well be $250,000—that’s a number we’ve seen in tax policy the last few years)… If your adjusted gross income on your tax return is over $250,000, you may not benefit any longer from the 20% capital gains rate. Maybe they’ll raise it in steps from $250,000 to $500,000—it’s 25%. It could go up as high as eventually being subject to the full 39.6%.

Weinstein: Carrying interest has been the most visible debate. It’s been happening. I’ve been in private equity for over a decade and it’s been a debate since I started in the industry. That was even under Republican administrations and Republican Congresses, because you just always have had a voice talking about this. It really flared up as a debate around 2007 and 2008, most visibly.

Bailine: One problem they have with addressing carried interest is that anytime they have crafted a law it doesn’t just hit private equity; it’s much broader and it hits mom-­‐and-­‐pop corporations. It’s difficult to  craft  a  law  that  would  address carried interest  and affect only very large or very profitable organizations.

Then, that causes Congress to look at alternative ways of addressing, again, the fact that a lot of income may be flowing to a few (the so-­‐called income inequality) and how do we address that? It’s mostly a blank slate. They have a lot of things, from fees to interest to deductibilities, at the portfolio level.

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