IRS Fails to Act on Tax Strategy of Private Equity Firms

Despite engaging in a five year probe into the tax strategy utilized by managers of private equity firms, the IRS chose not to pursue any actions. This leaves private equity tax practices in a “legal gray area” that an article in Reuters today said New York’s attorney general was now exploring.

Private equity firms have found themselves under increased scrutiny, particularly in an economically and politically turbulent era. The article in Reuters, using a source familiar with the matter, stated that New York Attorney General Eric Schneiderman has subpoenaed documents from more than twelve private equity firms on how they handle the tax bills of their managers.

Bain Capital LLC, a private equity firm that Republican candidate Mitt Romney founded and once led, was among the firms being looked at by the Internal Revenue Service. Bain, KKR & Co LP, TG Capital, and other firms were under scrutiny in regards to a practice known as “management fee waivers.”

With a “management fee waivers,” those in management positions at the private equity firms would convert a chosen part of their pay into investment income. The practice of converting a portion of their pay into investment income would reduce the tax rate, leaving it around 15 percent. This percentage can be equated with the amount that managers would pay for “carried interest,” another investment gain that the individuals would receive when they buy, manage, or sell a company.

There are those though—particularly Democrats in Congress—who adamantly believe that the tax status of carried income should be revised, making it ordinary income instead of its current status as investment income.

The IRS announced in November of 2007 that it was investigating such practices by private equity firms. Nothing has transpired on their end at this point. It is not known whether any auditing of private equity firms occurred during the period, or why no actions were publically undertaken in regards to this issue.

As states by a tax lawyer employed by the IRS when the probe was initially announced, IRS auditors faced an uphill battle when it came to investigating private equity firms. Their structures, he said, are highly complex and do not led themselves easily to scrutiny.


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