June 18, 2013
Interviewed by: David Snow
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The End of Pass-Through?

There are potential changes brewing on Capitol Hill that would impact the way partnerships are taxed. Rick Bailine, RSM’s National Tax Leader, spells out what this means for private equity and what the industry can do to prepare for these tax changes.

There are potential changes brewing on Capitol Hill that would impact the way partnerships are taxed. Rick Bailine, RSM’s National Tax Leader, spells out what this means for private equity and what the industry can do to prepare for these tax changes.

The End of Pass-Through?
A Privcap conversation with Rick Bailine of RSM

David Snow, Privcap:

Today we are joined by Rick Bailine of RSM. Rick, welcome to Privcap today

Rick Bailine, RSM:     

Thank you David.

Snow: You are in charge of the Washington National Tax Practice for RSM, you’re based in Washington D.C.

Bailine:     That’s right.

Snow: You are deep into the world of taxes and the political forces that shape taxes, a world that myself and many of our viewers don’t know at all. Before I get to the main point of our conversation which is about the partnership tax, can you talk about what you follow and what tea leaves you read in order to gauge what might be coming down the road as far as tax changes?

Bailine: First of all, David, I’ve had the great benefit of being in Washington since 1978. My first four years were with the IRS and from 1982 on I’ve been in public accounting. So I’ve got to know a great many people in the city and these are the types of people who have their eyes and ears focused on Capitol Hill. And we also have two partners in our office who spend a considerable amount of their time with their eyes and ears focused on Capitol Hill. And we meet on a regular basis, really on an as necessary basis, we might meet twice in a day if it’s a busy day, we might not meet for two or three days like when Congress is in recess for instance in August.

So what you do is you talk to people that you’ve worked with over the years and we do have people at RSM who are focused on Capitol Hill. And we try to keep ourselves abreast of changes that are happening on Capitol Hill, particularly in the tax arena.

Snow: I’d like to talk to you about a possible change coming down the road that would be profound for U.S. business in general and private equity in particular, that is a change to the partnership tax or the way that partnerships are taxed. Why do you believe that there might be a change coming and what signs were you reading that made you think that that’s the direct we were headed?

Bailine: Well right now obviously David, the country is looking for ways to narrow the spending gap and revenue gap. We’re running very, very significant deficits. For the last couple years, the deficit has been over a trillion dollars a year. To put that in perspective, in 2011 the total tax revenues collected by the United States were $2.3 trillion dollars and the government spent $3.6 trillion. So you can see that’s a third gap, I mean the gap between the revenues and the spending is very, very large. So Congress is looking for new sources of taxes. In the last twenty-­‐five years, corporate taxes in America, the traditional C corporation, in 2011 their share of the total tax revenue package was less than eight percent of total tax revenues.

And that’s not because they’re avoiding paying their fair share, it’s because over the last twenty-­‐five to thirty years, more and more businesses have stopped doing business as C corporations, and they have changed the way they do business and they now do it as a pass through, either a partnership or a subchapter S corporation. Partnerships are far more predominant and growing faster because subchapter S corporations have certain restrictions that partnerships don’t have. There’s a limit on the number of shareholders, there’s a limit on the types of stock, partnerships are much more flexible. And in the last fifteen years, as you know David, with the advent of the LLC, you and I can form an organization which for State Law purposes is still a corporation. So we get a lot of the traditional protections that a corporation has, but we can elect under the code to treat that LLC as a partnership, a pass through entity. So what’s happening is there are far, far fewer business revenues that are being taxed at the entity level, now more and more the business revenues are being taxed only at the ownership level or the individual level.

Snow: And what have been some pronouncements from you know, key authorities in Washington that have furthered your suspicion that partnerships and pass through entities might be targeted.

Bailine: Well there have been a couple proposals to start potentially taxing partnerships as if they were corporations. Now, there’s not a lot of meat on the bones, we don’t know exactly how they would go about it, but there were a couple proposals which really did not receive a lot of support. However in the last four years, former Secretary of the Treasury, Timothy Geithner has on a couple of occasions spoken out that in his view, and

whenhemadethesecomments,hewasinfacttheSecretaryofthe Treasury. In his view, he was referring to the corporate taxes being something that’s elective and he did not believe it was appropriate for the corporate tax to be elective. And obviously what he’s speaking about, he’s not trying to say that a company like General Electric or General Motors can elect whether or not to pay tax, that’s not what he saying.

Butheissayingiswhenentrepreneurscometogethertoformabusiness, they have a choice, do they want to be a C corporation which would be taxed twice, or do they want to be a partnership, or an S corporation which gets taxed once and they don’t get taxed at the entity level. And as I said, in the last twenty-­‐five years, certainly the statistics show that the growth of American business in pass through form, had gone from about ten percent of business revenues to now it’s about forty-­‐five percent of business revenues and growing, so corporate tax revenues are way down.

Snow: If something did go through, and of course we don’t know what form or there’s no meat on the bones yet, as you say. How profound of a change would this be for, let’s call it the private investment industry which is done almost entirely out of pass through entities, from real estate to oil and gas to regular way private equity.

Bailine: I think it would have a very significant impact on private for exactly the reasons you’re stating. Most private equity does do business in a partnership form, so it has been their experience that they are not subject to this double layer of taxation. Also, and again this is just a guess, but certainly if the government does go down this path, they’re not going to pass a law in my judgment that would just suddenly start to tax all partnerships as if they were corporations. What they’re going to do of course of they’re going to say we’re not interested in taxing the mom and pop businesses, the smaller businesses, the middle market businesses. They’re probably going to draw a line and say we’re only going to go after the bigger partnerships. Well again, as you know, private equity frequently has very, very significant revenues in their partnership and my guess would be these would be the types of partnerships that are going to be right in the crosshairs of any change that’s coming.

Snow:    What can private equity firms do or what can the industry do collectively to prepare? Is there anything at all?

Bailine: Well yeah, I do think the answer to that is yes. Certainly I think they have to be aware of this. This is not a topic that’s gotten a lot of press and I’m pretty sure the administration’s pleased about that because it would be a very major change. So my advice would be really twofold. One, be vigilant, keep your ears to the grounds. This thing has been surfaced at the Secretary of Treasury level, so it’s not just a pipe dream. And number two,

I don’t want to use a bad word like lobbying, but in fairness, you can do things to influence where this law is going to go and I do think if you’re vigilant and if you keep your eye on the ball, there is the potential that maybe some of this can be addresses before it happens.

Snow: But despite all the lobbying that could possibly happen, if it does go through things will change. Does that just mean that the private equity business or any businesses based on a pass through entity will simply be less profitable.

Bailine: Well again, depending on where they draw the line, it could be the case that larger partnerships are going to face a situation where they would in fact be less valuable because they will be subject not just to the traditional tax we know now where profits are passed through to the owners, but they would do something to cause a tax at the partnership level. And what they’re likely to do, I mean if you think about a traditional partner, so let’s assume you and I are partners in a partnership. For the sake of argument, the partnership makes a hundred dollars and we are both equal partners. Well there is nothing left in the partnership at the end of the year because fifty dollars of the profits are distributed to you, even if it’s not actually distributed, it’s deemed distributed to you and you are taxed on it. And fifty dollars would be deemed distributed to me. Well if there’s nothing left in the partnership to tax, what kind of teeth would this have? Well the first thing they’re going to have to do is limit how much of a partnership’s profits can actually be distributed to the partners and still be deductible from the income of the partnership.

And again, my guess is they will go after the larger partnership, so perhaps the one area planning that might exist is some of the funds that get formed are going to have to be somewhat smaller. Instead of having one investment fund and make three or four investments through that fund, you might actually be setting up a fund for each investment so you keep the investments lower.

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