FORTUNE — With the annual tax deadline approaching next week, middle class Americans may be wondering how private equity titans like Mitt Romney get away with such low tax rates on their millions in income. The answer is that private equity firms are treated as passive investors in the companies they buy and — unlike you and me — partners in these firms are taxed at the lower capital gains rate (typically 20%) on most of their income. But are private equity firms merely investors, or are PE partners active managers and employers of their acquired companies?
The Internal Revenue Service recently established a taskforce to review the way private equity is taxed. At issue is the question of whether PE funds are similar to mutual funds or whether they are in the business of buying, developing, and then selling companies at a profit — much as real estate developers buy properties and develop them for resale to customers. Much hinges on the answer.
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In our new book,
Private Equity at Work: When Wall Street Manages Main Street
, Cornell University Professor Rosemary Batt and I show that private equity is a different breed of investor. The partners in a PE firm do much more than simply decide which companies their funds should acquire. They decide how much debt to use in acquiring the company, and this debt structure drives the management plan the company is required to follow. The management plan sets the strategic direction of the company — which units to sell off or shut down; whether to demand wage and benefit concessions to cover payments on the new debt; whether to replace top managers loyal to the company and its creditors and employees with new managers loyal to the PE firm; and who should sit on the company’s board of directors.
What’s more, the general partner (GP) oversees hiring and compensation practices, participates in labor negotiations, decides whether to exit an employee pension plan, collects fees from the company for advisory and consulting services, and may require the company to pay dividends to the PE fund partners (its shareholders) out of current cash flow or by selling junk bonds to raise funds for a dividend recapitalization.
As the cases in our book illustrate, PE firms actively manage the companies they acquire. Yet the courts and the tax authorities have long treated private equity partners as passive investors and not active managers, exempting them from laws and regulations that apply to other businesses. For example, under current interpretations of laws, they are exempt from the Worker Adjustment and Retaining Notification (WARN) Act that governs notification of employees in case of a plant shutdown. Partners at private equity firms and at the funds they sponsor are also exempt from the Employee Retirement Income Security Act (ERISA) that governs treatment of a pension plan in case of bankruptcy, as well as provisions of the tax code that govern the tax liabilities of a trade or business.
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This happy state of affairs for private equity was abruptly upended last July by a surprise appeals court ruling in a pension case involving PE firm Sun Capital Partners. Less than two years after the firm was acquired by brass and copper manufacturer Scott Brass in a leveraged buyout, the company declared bankruptcy and stopped making payments to the employees’ pension fund. The question before the appeals court was whether Sun Capital and its funds were passive investors and not liable for a $4.5 million payment to the pension fund or were actively engaged in managing Scott Brass and should be treated as engaged in a “trade or business” under ERISA
The appeals court last year ruled that Sun Capital was engaged in a trade or business, a move that could have far-reaching tax implications for partners at PE funds; it could cost them billions of dollars more. As for the payment to the employee pension fund, a final decision on that has been returned to the lower court. Sun Capital owns 100% of Scott Brass but divided this ownership between two of its funds, neither of which individually owns at least 80% of the company as required under ERISA to be obligated to make the pension payment.
Three major changes could follow if the IRS finds that a PE fund is engaged in a trade or business: First, the profits earned through buying and selling portfolio companies would be taxed as ordinary income rather than at the lower capital gains rate. Second, tax-exempt limited partners could owe taxes for unrelated business income on the PE fund’s profits. And third, foreign investors who currently aren’t taxed in the U.S. could be taxed as effectively connected with a trade or business in this country.
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The facts on the ground belie private equity’s claim that it is merely a passive investment vehicle. Ending the charade would ensure that private equity partners are treated the same way as other businesses. It’s unclear whether Congress is ready to engage with the private equity industry over tax fairness, but perhaps the IRS, which is in charge of interpreting the tax code in a fair and consistent manner, will take on the job of ending the special tax breaks the industry currently enjoys.
Eileen Appelbaum is a senior economist with the Center for Economic and Policy Research and a co-author of the forthcoming book, Private Equity at Work: When Wall Street Manages Main Street.
