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The truth about Private Equity and tax policy
The Service Employees International Union (SEIU) has portrayed private equity partners as the beneficiaries of unfair tax “loopholes.” These assertions are directly contradicted by tax law and a significant body of legal precedent, both in the United States and internationally.
Specific issues raised by the SEIU are examined below:
PE partnerships are taxed like all other partnerships
Private equity partnership profits are taxed just like profits earned by venture capital, real estate, and all other partnerships, including ones created by families in which a parent provides equity while a child provides labor and ideas to build something of value.
The claim that PE partners pay taxes at a lower rate than janitors and policemen is a misleading sound bite. Private equity partners pay regular income tax rates of as much as 35 percent on their salaries and fees, just like everyone else. And they pay capital gains rates on long-term investment income, just like any American with mutual funds or other capital investments.
With income tax rates varying from 15 to 35 percent, the typical private equity partner actually pays taxes at a much higher rate than the average American, even those who are well off. According to the latest figures from the Congressional Budget Office, Americans with average annual pre-tax income of about $85,000 paid an effective federal income tax rate of six percent in 2005.
The top one percent of all American tax payers paid an effective federal income tax rate of 19.4 percent. Sound bites and class warfare are not a substitute for facts.
Private Equity partners are owners, not money managers
Private equity investors are owners who directly contribute to the value of the companies they buy. Unlike money managers, private equity investors sit on boards of directors, hire and fire senior executives, develop strategic plans and make decisions integral to the future success of the company.
In fact, without their involvement, there would likely be no capital gain – it exists because of their work. PE partners cannot earn any profits unless they return to investors their principal plus the first eight to 10 percent of partnership profits. In addition, PE partners risk their own capital. If the companies they acquire are sold at a loss, PE partners lose some or all of their own equity investment.
“Carried Interest” is taxed as a capital gain by the U.S.’s major international competitors
Leading European countries, including the United Kingdom, France, Ireland, and Spain, tax carried interest as a capital gain. By adopting a policy that would tax carried interest as ordinary income, Congress would put U.S. investment firms at a competitive disadvantage, risking a migration of investment in U.S. businesses to jurisdictions with more hospitable tax climates.
Interest expense deductions are available to everyone and ultimately are taxed
Every business in America, small, large, public, private, is entitled to deduct from its taxable income the interest expense its pays on the money it borrows to finance its operations, whether conducting business as a sole proprietorship, partnership or corporation. PE firms are no different.
The interest deduction is intended to encourage borrowing for investment purposes. For every business or individual that deducts interest expense from their taxes, there is a corresponding lender – whether it is a savings and loan association or a large investment bank – that pays federal taxes on the interest income it receives from the borrower.