Tuesday, October 14, 2014

Private Equity Magic: Converting Ordinary Income into Capital Gains

Private Equity Magic: Converting Ordinary Income into Capital Gains

When a private equity executive runs for public office, we get an opportunity to peak at the source of his or her wealth.  Last week Bruce Rauner, founder of GTCR and candidate for Illinois Governor, issued his IRS Form 1040 for 2013.   Last November he released the same information for 2011 and 2012.  Mr. Rauner didn’t release any of the supporting schedules, so we don’t know precisely how he derived his income.  I’ve created a summary table below (don’t try adding the figures up because I’ve omitted some of the smaller items of income).

There’s no question that Mr. Rauner has done extremely well in the last three years as his taxable income has risen from $28.2 million in 2011 to $60.8 million in 2013.[1]  As a candidate, Mr. Rauner had to file a State of Economic Interests (SEI) with the Illinois Secretary of State which lists all his stock, bond and partnership interests.[2]  Although the SEI doesn’t list the specific amount of each investment, you can get an idea of Mr. Rauner’s holdings.  Like many wealthy financiers Mr. Rauner has interests in a couple of sports franchises: the Chicago Bulls and Pittsburgh Steelers.  He also has holdings with a variety of private equity, real estate, and hedge funds, including extensive interests in his former firm’s funds.  No surprise.

Here’s the surprise.  Mr. Rauner had no wage income in any of the reported tax years.  Since he resigned from GTCR, his lack of wages in 2013 might be understandable.  But how can he have avoided having any wage income in 2011 or 2012?  In raising GTCR’s tenth fund, SEC filings show that GTCR’s principals expected to earn fees of $270 million out of $3 billion raised.[3]  For GTCR’s ninth fund, regulatory filings show that the partners expected wages and fees of $35.4 million on $393 million of investor capital.[4]  Many of GTCR’s SEC filings aren’t available electronically, so it’s hard to get anything approaching a complete picture.  However, it is apparent that the PE executives at GTCR followed the well-worn path of converting ordinary income into capital gains, and it looks like they did a good job of it.

Rauner Tax Return: 2011-2013
Selected Items (all figures in millions)

What’s going on?  Mr. Rauner and his partners were well represented by lawyers and accountants as they set up GTCR and launched each of its funds.  As taxpayers they sought to structure the funds and include terms in the partnership documents that would help to reduce their tax bills.  Meanwhile most of their large investors, like Washington State Investment Board, were indifferent to the tax consequences (public pensions aren’t subject to taxation).  It appears that Mr. Rauner and his colleagues used one or more tactics to make all their income disappear.

There’s no one better at explaining private equity’s tax strategies than Greg Polsky, Willie Person Mangum Professor of Law at the University of North Carolina. [5]  While most of us are familiar with carried interest, Mr. Polsky has shown that PE uses a variety of other strategies to reduce their tax bills.  Carried interest is, of course, the portion of an investor’s profits that are given to the partners as a performance incentive.  Those profits are taxed as capital gains even though partner did not invest his own capital.  The Obama administration has repeatedly proposed ending this tax preference, as Mr. Rauner and many other PE practitioners have availed themselves of its generous benefit.  The taxation of carried interest, however, doesn’t explain what happened to Mr. Rauner’s wages.

PE firms go much further in trying to reduce their tax bill.  As Mr. Polsky has shown, they often engage in three other strategies.  First, they may waive their management fee.  Instead of receiving 1.5% or 2% as management fee, the partners reduce their capital commitment to the fund by a proportionate amount, and the LPs make up the difference.  So instead of receiving income, the partners have a larger capital account.  When the fund generates a profit, they receive capital gains treatment on what should have been fee income.  Since most of the investors aren’t tax sensitive, they don’t care that they’ve lost the deductibility of the fee as an ordinary expense.  When you are a wealthy PE executive you certainly don’t need income, so this strategy is terrific.  As Mr. Polski has pointed out, it’s not clear that it passes muster under current law and regulation.  Nonetheless, it has worked so far.

The second strategy designed to wipe out any remaining profit is to misallocate the firm’s expenses entirely against the management fee instead of apportioning some of those expenses against carried interest.  In other words, the PE firm charges as much expense as possible against the management fee until the firm shows no profit.  This too is a questionable practice, but it has worked.

The final strategy is designed to increase the value of deductions.  Since most investors, like public pension plans, are tax indifferent, it is far more effective to create deductible expenses for portfolio companies.  Enter the transactions and monitoring fees that I’ve discussed on many occasions on this blog.  If the PE firm charges these fees to portfolio companies but offsets the burden to investors via a credit on the management fee, the investors become indifferent about these additional fees.  However, the IRS shouldn’t be.  If these types of expenses had been borne by investors, they’d have had little value as deductions.  However, by charging them to portfolio companies these fees become useful deductions.  Moreover, there’s a real question whether these fees have a legitimate purpose in the first place.

Admittedly, we don’t have the documentation to show precisely how Mr. Rauner managed to avoid paying ordinary income.  However, it seems inconceivable that Mr. Rauner wouldn’t avail himself of the tactics commonly used by PE executives.  In my mind, his tax returns have little to do with the question of whether Mr. Rauner should become the next governor of Illinois.  There’s a larger point.

What Mr. Rauner’s tax returns illustrate is the desperate need for tax reform and more aggressive enforcement by the IRS.  Only a tiny proportion of taxpayers can take advantage of the tax code and the creativity of their accounting and legal advisors to convert ordinary income into capital gains.  Even most of Mr. Rauner’s former employees aren’t capable of playing this game.  They receive W-2’s from GTCR and have to report income on line 7 of form 1040.  It’s only a small group of very wealthy financiers who get to conjure up these benefits.

We need more Professor Polskis.  We need the IRS to show some backbone.  And we need to be far more outraged by these kinds of tactics, which place more of the tax burden squarely on our own shoulders.

[1] http://brucerauner.com/wp-content/uploads/2014/10/1040-Rauner-2013.pdf
[2] https://www.scribd.com/doc/187238375/Financial-Disclosures
[3] http://www.sec.gov/Archives/edgar/data/1502604/000150260410000001/xslFormDX01/primary_doc.xml
[4] http://www.sec.gov/Archives/edgar/vprr/07/9999999997-07-002377
[5] http://www.law.unc.edu/faculty/directory/polskygreggd/

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