In the gilded realms of private equity, where mega deals and mega paydays beckon, the masters of leveraged buyouts are feeling a little put out.
From Park Avenue to Palm Beach, the conversation keeps turning to the same uncomfortable subject: an onslaught of taxes and the closing of the Billionaires’ Loophole.
After years of idle threats, Washington is talking seriously about ending the tax break that has helped private equity become one of the most lucrative corners of U.S. finance. Adding to the injury, other taxes on income and capital gains would also rise.
Private-equity types are, predictably, outraged.
For wealthy people like them, going after carried interest—basically, their cut of the profits—strikes many as anti-business, if not anti-American.
Some are expecting the changes to prompt early retirement. Others are quitting New York for no-income-tax Florida. One is dreading telling his kids he’s moving the family to Puerto Rico; he hired an attorney to look into the logistics. Another, straight-faced, likens the developments to—his term—reverse discrimination.
Over the top, maybe. But a lot of money is at stake.
The Internal Revenue Service characterizes carried interest as capital gains, rather than ordinary income. That’s the difference between paying the 23.8% total investment rate, including a levy that funds Obamacare, versus the 37% rate for salaries and wages.
But now the Biden administration wants to label both as ordinary income, effectively doubling the capital gains tax for the highest earners, and meaning that profitable perk—the Billionaires’ Loophole—might vanish at last. The combo of rising income and capital gains taxes, scrapping the carried interest break, and paying additional state and local taxes could push total levies for some to 60%.
And the proposed changes may come on top of more scrutiny. A Treasury Department report released Thursday estimated that wealthy taxpayers as a group are hiding billions of dollars of income, bolstering the Biden administration’s call for Congress to approve expanded IRS funding.
A decade ago, private-equity billionaire Stephen Schwarzman likened the mere possibility of raising taxes on his industry to Adolf Hitler invading Poland in 1939. (Schwarzman later apologized for the remark. He declined to comment for this story).
If President Joe Biden gets his way, hedge funders would get pinched, too, but not as much as private equity. Scrapping the carried interest loophole could raise an estimated $15 billion from the wealthy over 10 years, according to a congressional committee.
A big spender in Washington, private equity has beaten back the taxman before and was spared under President Donald Trump. This time feels different, however. Industry insiders say they’re growing increasingly resigned to the prospect of paying more in taxes. For obvious reasons, few want to be quoted by name.
Private equity’s formidable Washington lobby, the American Investment Council, is willing to talk. It’s working to convince members of Congress to protect the industry’s interests.
“During this economic recovery, why would you try to do anything that would thwart the ability of private capital and the incentives for continued investment,” says AIC president Drew Maloney. “You’re going to have a group of policy makers that don’t want to disrupt that.”
He goes on: “At the end of the day, private equity wants to be consistently treated with capital gains, and let’s see how that flows and the debate unwinds.”
The dollar signs tell the story. Take Blackstone Group Inc.’s Schwarzman, perhaps the industry’s biggest name. Last year, he earned $78 million in “carry” including securities he could sell later on—the bulk of his compensation—and $524 million in dividends on his stake in Blackstone. Under the Biden plan, his carry take would shrink to $44 million and his dividend pay would fall to about $300 million. And then all of that would be whittled down even more by city and state taxes.
For most senior people in private-equity land, the vast majority of compensation comes from carried interest, while the junior employees derive their pay from salaries. Under the Biden carried-interest plan, the average partner at a major private-equity firm, who would make $30 million in carry if certain returns are met, could expect to pay about $13 million in taxes, up from $7 million under the current system, according to a Bloomberg analysis of pay data by recruiting firm Heidrick & Struggles.
For an average vice president, who is likely near the top 1% of earners, they could pay as much as $2.3 million to the IRS, up from $1.2 million.
To put those figures in perspective, the U.S. median household income was $68,703 in 2019, according to the U.S. Census Bureau. The average tax rate the year prior was 13.3%, according to the latest figures from the IRS.
Granted, even some in private equity wonder if their industry’s long-protected tax setup is fair. The founder of one private equity firm says he never thought the arrangement would last – that it has been, in effect, a Wall Street giveaway. He’s based in Texas, which has no state income tax.
That’s not quite how wealthy New Yorkers see things, whether they’re in private equity or not. New York is hiking its tax on the rich in order to funnel money to schools, the homeless and more. Biden, meantime, is seeking new taxes on the wealthy to pay for his plan to reshape the economy as the pandemic recedes here.
Giving away 60% of one’s income is beyond a fair share, says the private-equity veteran planning his move to Puerto Rico.
Opponents of tax increases on the wealthy have been arguing that even the slightest increase will send affluent New Yorkers fleeing to Florida, the would-be Wall Street South. That may already be happening. Almost 10% of New York-area residents who moved during the pandemic fled for one of the nine states without income tax—and the bulk of them went to Florida, according to U.S. Postal Service data.
Blackstone, Thoma Bravo and Apollo Global Management Inc. are each opening offices in Florida. One of Apollo’s co-founders, Josh Harris, is considering changing his primary residency to the Sunshine State—a move that could lower his tax burden if he starts selling his stake in the firm after his planned departure next year.
A slew of hedge fund titans have moved there or have opened hubs for staff making the jump.
Doing away with the tax incentives that promote risk-taking could choke off the American ingenuity that’s created many of the world’s best businesses, one of the industry executives said.
“By taxing the value creation at a higher rate, you are actually penalizing these small businesses and emerging managers which are really driving the growth in the economy,” said Nitin Gupta, a managing partner at Flexstone Partners, which invests in private assets. “Those smaller PE-backed businesses tend to grow and hire at faster rates.”
According to Paul Gulberg, an analyst at Bloomberg Intelligence, a key argument for maintaining the carried-interest loophole is that it aligns the interests of the limited partners, who invest money in private-equity funds, and the general partners who actually cut deals and make investments. Changing the tax arrangement might encourage GPs to focus more on the short term— not necessarily a good thing.
And given how private equity has infiltrated virtually every corner of the nation’s economic life, funds might be tempted to simply pass along any tax increase to pension funds, college endowments and other investors. Big players could consolidate their power. Smaller ones might struggle to break through.
“It may make it slightly harder for emerging managers to compete for talent,” says Brendon Parry, managing director at TIFF Investment Management, which primarily invests in lower middle-market private equity and early-stage venture capital for endowments and foundations.
In a business where money is the ultimate measure, everything is relative. One private-equity partner concedes he’s well compensated. But he adds that next to the founders, he looks poor.
There’s not much that can seriously diminish the giddy fortunes that have already been made. The founders at the top four publicly-listed firms—Blackstone, Apollo, KKR & Co., Carlyle Group Inc.—have reached billionaire status, according to Bloomberg. The multimillionaires are too numerous to count.
And the counter argument, of course, is that if private equity is so good at what it does, it shouldn’t need a tax loophole to make money.
“You can make billions of dollars in this industry if you’re good and if it’s taxed at 43%, oh well,” said Elizabeth Edwards, founder of H Venture Partners, a Cincinnati-based venture fund. “You’ve got $600 million instead of $1 billion. You can’t take it with you.”