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Why the IRS should tax equity fund profits as ordinary income

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Ann Hermes/The Christian Science Monitor/File

(Read caption) 'Understanding Taxes' graphic design posters hang in the halls of the US Internal Revenue Service building in Washington, DC. The IRS should focus squarely on all of the business profits of private equity funds, and not just the profits allocated to the managers.

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For years, the battle over carried interest has focused on how to tax the compensation of private equity managers. But a careful reading of  the law suggests that all the business profits of these investment firms, not just the pay of their managers, are ordinary income, and should be taxed that way.

Until now, the analysis of this issue has simply accepted the funds’ profits as capital gains. But when researching a newly-published article, “Taxing Private Equity Funds as Corporate Developers,” I discovered that Congress intended capital gains to be defined narrowly so that ordinary profits—those that arise from the everyday operation of a business—would be taxed at regular rates.

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Private equity funds earn sizable profits, largely from acquiring companies, improving them, and reselling them (and they now manage much greater amounts of money:  $2.5 trillion in 2010, up from $100 billion in 1994). The funds report these profits as capital gains, and allocate a large share to their managers as reward for their services (which is how Mitt Romney achieved 14% effective tax rates).  But what if these profits are not capital gains at all?  And what if our tax rules have been incorrectly subsidizing the growth of these funds for the last two decades?

Our tax laws generally treat the profits of taxpayers that develop and sell property in the course of a trade or business as ordinary income. For example, real estate developers often take many years to buy, develop and resell property, and they report their profits as ordinary income. So, why should private equity funds that buy, develop and resell companies (or their stock) treat their profits as capital gains? 

Some believe that all gains from stock sales are capital. But that is not true: Equity that is held, for example, by a dealer (like a stock exchange floor specialist) is ordinary income. And private equity funds, like dealers, make a profit as middlemen: They both buy stock expecting to resell it at a higher price as remuneration for their intermediation efforts.

Although the public has expressed widespread astonishment at the low tax rates on the income of private equity fund managers, our lawmakers are frozen in response. Six years ago, Congressman Sander Levin (D-MI) first introduced legislation to treat any gains allocated to private equity managers as ordinary income. But his legislation stalled.  Instead, Congress has struggled to separate (and tax) only the labor, and not the capital, component of the private equity managers’ returns.  But these distinctions are overly complex and the latest versions of carried interest legislation are riddled with exclusions for “enterprise value” and other novel concepts.

But the biggest flaw of this approach is that it misses the point:  Business profits should be taxed as ordinary income. And private equity funds are the same as other businesses, in that they deploy capital, labor, and other inputs to make their profits.

The IRS should now focus squarely on all of the business profits of private equity funds, and not just the profits allocated to the managers. And it can write regulations to treat the profits as ordinary income without waiting for Congress to act.