How personal fairness companies keep away from taxes

Two weeks remained in the Trump administration when the Treasury Department enacted a series of rules regulating an obscure corner of the tax code.

Supervised by a senior finance officer whose previous job was helping the wealthy with tax avoidance, the new regulations were a huge win for private equity firms. They made sure that executives in the $ 4.5 trillion industry, whose executives often figure their annual wages in eight or nine digits, could avoid hundreds of millions in taxes.

The rules were approved on January 5th, the day before the US Capitol uprising. Hardly anyone noticed.

The Trump administration's parting gift to the buyout industry was part of a pattern that includes Republican and Democratic presidencies and conventions: private equity has invaded the US tax system.

The industry has perfected tax avoidance tricks that are so aggressive that at least three private equity officials have alerted the Internal Revenue Service to potentially illegal tactics, according to people with direct knowledge of the claims and documents verified by the New York Times. The previously unreported whistleblower allegations concerned tax evasion at dozens of private equity firms.

But the I.R.S., whose employees have been undermined after years of budget cuts, have put their hands up when it comes to overseeing the politically powerful industry.

While intensive investigations by large multinational corporations are common, the I.R.S. rarely conducts detailed audits of private equity firms, according to current and former agency officials.

There are "almost no such audits," said Michael Desmond, who this year served as Chief Counsel of the I.R.S. has resigned. The agency “just doesn't have the resources and know-how”.

One reason they are seldom audited is that private equity firms have built huge networks of partnerships to generate their profits. Partnerships do not owe any income tax. Instead, they pass those commitments on to their partners, which can run into the thousands at a large private equity firm. This makes the structures notoriously complicated for auditors to untangle.

Increasingly, the agency does not care. People on less than $ 25,000 are at least three times more likely to be screened than partnerships, whose income largely goes to the richest 1 percent of Americans.

The consequences of this imbalance are enormous.

According to a recent estimate, the United States is losing $ 75 billion annually to investors in partnerships who do not accurately disclose their earnings – at least a portion of which would likely be repaid if the I.R.S. more audits carried out. That is enough to roughly double the annual federal spending on education.

It's also a dramatic understatement of the real cost. It doesn't include the ever-changing maneuvers – often on the edge of the law – that private equity firms have developed to help their managers avoid income taxes on the roughly $ 120 billion that the industry gives their executives each year pays.

Private equity's ability to defeat the IRS, Treasury Department, and Congress goes a long way in explaining the deep injustices in the US tax system. When it comes to federal government funding, the richest of the rich in America – many of them come from the private equity industry – play by very different rules than everyone else.

The result is that men like Blackstone Group's CEO Stephen A. Schwarzman, who made more than $ 610 million last year, can pay federal taxes at rates similar to the average American.

Legislators have regularly tried to force private equity to make more payments, and the Biden government has proposed a number of reforms, including expanding the IRS's enforcement budget and closing loopholes. Pressure to reform took off after ProPublica recently revealed that some of America's richest men paid little or no federal taxes.

The private equity industry, which has a fleet of nearly 200 lobbyists and has spent nearly $ 600 million in campaign donations over the past decade, has in the past repeatedly undone efforts to increase its tax burden.

The I.R.S. Commissioner Charles Rettig, appointed by President Donald J. Trump, declined to be interviewed for this article. However, in a testimony to the Senate Finance Committee Tuesday, he admitted the agency was not doing enough to consider partnerships.

"If you are a wealthy cheater in a partnership, your chances of being audited are slightly higher than your chances of being hit by a meteorite," said Mr. Rettig. "For reasons of fairness and budget, it makes a lot more sense to chase after the big guys than to focus on the working people."

But that's not what the I.R.S. did.

Private equity firms typically borrow money to buy companies they think are ripe for a turnaround. Then they cut costs and resell the leftovers, which are often laden with debt. The industry has owned branded companies in almost every industry. Today, major assets include Staples, Petco, WebMD, and Taylor Swift's back music catalog.

The industry makes money in two ways. Companies typically charge their investors an administration fee of 2 percent of their assets. And they keep 20 percent of the future profits generated by their investments.

This share of future profits is called “carried interest”. The term comes from at least the Renaissance. Italian captains of ships were partially compensated with a share in the profits made on the cargo they carried.

The I.R.S. has long allowed the industry to treat the money it makes from carried interests as capital gains rather than ordinary income.

A lucrative award for private equity. The federal tax rate for long-term capital gains is currently 20 percent. The top federal tax rate is 37 percent.

The loophole is expensive. Victor Fleischer, a law professor at the University of California, Irvine, estimates it will cost the federal government $ 130 billion over the next decade.

Back in 2006, Mr. Fleischer published an influential article highlighting the injustice of tax treatment. It prompted lawmakers from both parties to try to close the so-called carried interest loophole. The “On and Off” campaign has continued since then.

Whenever legislation picks up pace, the private equity industry – along with real estate, venture capital, and other sectors that rely on partnership – has pumped up campaign submissions and sent top executives to Capitol Hill. Law after law died, mostly without a vote.

One day in 2011, Gregg Polsky, then a professor of tax law at the University of North Carolina, received an email out of the blue. It was from an attorney for a former private equity manager. The executive had at the I.R.S. claims her old company is using illegal tactics to avoid taxes.

The whistleblower wanted Mr Polsky's advice.

Mr. Polsky had previously worked as "Professor in Residence" at the I.R.S. served and in this role developed a specialist knowledge of the taxation of the enormous profits of private equity firms. Back in academia, he had published a research paper detailing a little-known but ubiquitous tax evasion technique in the industry.

Private equity firms have already benefited from low tax rates on their carried interests. Now, Mr Polsky wrote, they have found a way to apply the same low rate to their 2 percent administration fees.

The maneuver had been outlined a few years earlier by the Silicon Valley law firm Wilson Sonsini Goodrich & Rosati in a 48-page presentation with schematic diagrams and a language that only a finance manager could love. “Aim,” it said on a slide. "Change management fee economy to achieve a tax treatment of carried interest without reducing the GP cash flow or adding an unacceptable risk."

In short, private equity firms and other partnerships could forego some of their 2 percent management fees and instead receive a larger share of future investment returns. It was a bit of paper shuffling that radically lowered her tax bills without reducing her income.

The technology had a name: "Exemption from fees".

Soon the largest private equity firms, including Kohlberg Kravis Roberts, Apollo Global Management, and TPG Capital, incorporated fee waiver agreements into their partnership agreements. Some stopped using fee exemptions when they became public companies, but the tax avoidance device continues to be widespread in the industry.

"It's like washing your fees into capital gains," said Mr. Polsky, whose paper argued that the I.R.S. could use long-term provisions of the tax code to take action against fee exemptions. “They put magic words in a document to convert ordinary income into capital gains. They have no economic substance and can get away with it. "

That's why the whistleblower came forward.

Polsky began speaking to the former private equity manager whose I.R.S. Lawsuit accuses three companies of illegally using fee exemptions. (Whistleblowers receive part of what the I.R.S. gets back based on their claims.)

It wasn't long before Mr Polsky heard from a second whistleblower. And then a third.

The whistleblowers – whose previously undisclosed claims are not public but have been verified by The Times – had received dozens of partnership agreements from private equity and venture capital firms unrelated to previous peers in the industry detailing the fee waivers.

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June 11, 2021 at 1:46 p.m. ET

The arrangements all had the same basic structure. Suppose a private equity manager were to receive an administration fee of $ 1 million, which would be taxed as normal income, now at a rate of 37 percent. As part of the fee waiver, the manager would instead agree to collect $ 1 million as a portion of future earnings that it would claim are a capital gain subject to 20 percent tax. He would still get the same amount of money, but he would save $ 170,000 in taxes.

The whistleblowers, two of whom had hired Mr. Polsky to advise them, argued that this was blatant tax evasion. The rationale behind taxing managers' compensation at the capital gains rate was that they involved significant risk; these concerned almost none.

Many of the agreements even allowed partners to receive their waived fees if their private equity fund lost money.

That was the case with Bain Capital, on whose tactics a whistleblower attacked the I.R.S. in 2012. That year, Bain's former boss, Mitt Romney, was the Republican candidate for president.

Another whistleblower's claim described fee waivers at Apollo – one of the world's largest buyouts with $ 89 billion in private equity.

Apollo said in a statement that the company has stopped using fee waivers since 2012 and "none of the I.R.S. Inquiries about the use of fee exemptions by the law firm. "

Induced, at least in part, by the whistleblower claims, the I.R.S. began examining fee waivers with a number of private equity firms, according to agency documents and attorneys representing the firms.

This would be the last time the I.R.S. Private equity was seriously scrutinized and it wasn't going to do much.

At the beginning of his first term in office, President Barack Obama came up with the idea of ​​taking action against carried interest.

Private equity firms mobilized. Blackstone's lobbying spending soared nearly a third that year to $ 8.5 million. (Matt Anderson, a Blackstone spokesman, said the company's officers "are among the largest single taxpayers in the country." He would not disclose Mr. Schwarzman's tax rate.)

The legislature got cold feet. The initiative failed.

In 2015, the Obama administration was more modest. The Treasury Department issued regulations banning certain types of particularly aggressive fee waivers.

But with this formulation, the new rules codified the legitimacy of fee exemptions in general, which up until this point had been viewed as abusive by many experts.

To the frustration of some I.R.S. Officials now had a roadmap for private equity firms to build the agreements without conflicting with the government. (The agency continued to review fee waivers at some firms where whistleblowers had raised concerns.)

The then finance minister, Jacob Lew, joined a private equity firm after leaving office. So did his predecessor in the Obama administration, Timothy F. Geithner.

Inside the I.R.S. – which lost roughly a third of its agents and executives between 2008 and 2018 – many viewed private equity's interlocking partnerships as intended to confuse auditors and tax evasion.

An I.R.S. Agent complained that "income is being pushed down so many notches that you can never find out where the real problems or double deductions are," according to a 2014 investigation by the US Government Accountability Office. Another agent cited the purpose of the large partnerships appeared to "make it difficult to identify sources of income and tax havens".

The Times reviewed 10-year annual reports from the five largest publicly traded private equity firms. There was no sign that the companies ever owned the I.R.S. extra money, and they only referred to minor exams that they said would not affect their finances.

Current and former I.R.S. Officials said in interviews that such audits generally included questions such as business travel expenses, rather than larger statements of their taxable profits. Officials said they were unaware of the recent major audits of private equity firms.

For a while it looked like there would be an exception to this general rule: the IRS exemption reviews spurred on by the whistleblower allegations. But it soon became clear that the exertion was lacking teeth.

The agency has not audited most of the 32 private equity firms that were the subject of whistleblower allegations, according to an I.R.S. Document reviewed by The Times. According to two people familiar with the reviews, the agency appears to have collected only small amounts of back taxes so far, including less than $ 1 million in total from two companies. (A handful of audits are ongoing.)

In 2014 the I.R.S. began examining fee waivers from Thoma Bravo, a large San Francisco private equity firm that owns companies like McAfee and JD Power, according to The Times-verified records. One of the whistleblowers had claimed that Thoma Bravo's managers were avoiding taxes by claiming that their fee income waived were capital gains, when the risk involved was negligible.

Agents tried to impose taxes and fines on Thoma Bravo, the records show. The company appealed. An internal I.R.S. Review panel on one side with Thoma Bravo. The challenge was over. "We do not propose adjustments" to the company's tax returns, an I.R.S. Officials at the agency's Chicago office briefed Thoma Bravo in a July 2018 letter verified by The Times.

A spokesman for Thoma Bravo declined to comment.

Kat Gregor, tax attorney at law firm Ropes & Gray, told the I.R.S. had challenged fee waivers used by four of her customers that she would not identify. The auditors seemed to her inexperienced in the thicket of tax law for partnerships.

"It's like choosing someone who is used to doing an interview in English and telling them to do it in Spanish," said Ms. Gregor.

The audits of their customers were completed at the end of 2019. Nobody owed any money.

As a presidential candidate, Mr. Trump pledged to “eliminate the carried interest deduction, the familiar deduction, and other special interest loopholes that were so good for Wall Street investors and people like me, but were unfair to American workers. ”

But his administration, armed with veterans of the private equity and hedge fund worlds, pulled out of the subject.

In 2017, when Republicans rolled out a major package of tax cuts, Democrats tried to insert language that would recoup some revenue by withdrawing more from private equity. They failed.

"Private equity is so rigorous and so aggressive, and always says that Western civilization will end if it has to pay normal income taxes annually," said Senator Ron Wyden, an Oregon Democrat.

While White House officials claimed they wanted to fill the gap, Republicans in Congress resisted. Instead, they have taken a much milder measure: private equity officials must hold their investments for at least three years before they can enjoy preferential tax treatment for their carried interests. Steven Mnuchin, the Treasury Secretary who previously ran an investment partnership, signed.

"We have tried to strike a balance between protecting the tax base and making sure we do not inadvertently penalize legitimate business and investing activities," said George Callas, senior tax counsel to Paul Ryan, speaker of the House of Representatives.

According to McKinsey, this was a symbolic gesture for an industry that typically holds investments for more than five years. The move, which is part of a $ 1.5 trillion tax cut package, is expected to generate $ 1 billion in revenue over a decade.

Private equity cheered. One of the top lobbyists in the industry praised Mr. Mnuchin and praised him as "an all-star".

Mr Fleischer, who had raised the alarm over carried interest a decade earlier, said the measure was "structured by the industry to appear like it is doing something while affecting it as little as possible".

Months later, Mr. Callas joined the law and lobbying firm Steptoe & Johnson. Private equity giant Carlyle is one of its largest clients.

It took the Treasury Department over two years to propose rules that spell out the fine print of the 2017 law. The Treasury Department's suggested language was strict. A suggestion would have been I.R.S. Auditors investigating internal transactions that private equity firms could use to circumvent the law's three-year holding period.

The industry, so pleased with the tepid law of 2017, was in an uproar over the strict rules that Treasury officials are now proposing. In an October 2020 letter, the American Investment Council, led by Drew Maloney, a former advisor to Mr Mnuchin, noted how private equity had invested in hundreds of companies during the coronavirus pandemic and said the Treasury Department's overzealous approach would harm the industry.

The Treasury's chief tax officer, David Kautter, was responsible for the rules. He was previously the national tax director at EY, formerly Ernst & Young, when the firm marketed illegal tax evasion that resulted in a federal criminal investigation and settlement of $ 123 million. (Mr Kautter has denied having been involved in the sale of the accommodation, but expressed regret that he did not talk about it.)

Under his supervision in the Treasury, the rules that were being developed softened, including with regard to the three-year holding period.

In December, a handful of tax officials working on the regulations informed Mr. Kautter that the regulations were not ready. Mr Kautter overruled his colleagues and urged them to be dealt with before Mr Trump and Mr Mnuchin left office, according to two people familiar with the process.

On January 5th, the Ministry of Finance presented the final version of the regulations. Some of the toughest regulations had disappeared. Among these was the one who made the I.R.S. to review transactions between different companies controlled by the same company. The result was that it became much easier to maneuver around the three year holding period.

"The government gave in," said Monte Jackel, a former I.R.S. Lawyer who worked on the original version of the proposed regulations.

Back in the private sector, Mr. Mnuchin is setting up a mutual fund that could benefit from his department's weaker rules.

The charm of private equity continued even during the pandemic.

The five largest publicly traded companies reported net profits of $ 8.6 billion last year. They paid their executives $ 8.3 billion. In addition to Mr. Schwarzman's $ 610 million, KKR co-founders each made approximately $ 90 million and Apollo's Leon Black received $ 211 million, according to Equilar, an executive compensation consultancy.

The lawyers in the industry have largely deciphered the 2017 law and discovered new ways of tax avoidance for their clients.

Kirkland & Ellis law firm, which Thoma Bravo helped fight the I.R.S. represented, now advises clients on techniques to circumvent the three-year holding period.

The most popular is known as the "carry waiver". It enables private equity managers to hold their carried interests for less than three years without paying higher tax rates. The technique is complicated, but it involves temporarily transferring money to other investment vehicles. That gives the industry more flexibility to buy and sell things whenever it wants without triggering a higher tax rate.

Private equity firms don't send this. But there are clues. In a recent presentation by Hellman & Friedman to a Pennsylvania pension scheme, the California private equity giant included a number of small print disclaimers. The last pointed to the company's use of carry waivers.

The Biden government is negotiating its tax reform agenda with Republicans who have aired advertisements attacking the proposal to increase the IRS budget. The White House is already pulling back on some of its most ambitious proposals.

Even though the agency's budget has been increased significantly, veterans of the I.R.S. I doubt it would make much of a difference when it comes to questioning complex partnerships.

"If the I.R.S. If we started recruiting now, it would take them at least a decade to catch up, ”said Mr Jackel. "You don't have enough I.R.S. Agents with enough knowledge to know what to look for. you are so exaggerated that it's not funny. "