The Taxation of Private Equity Funds

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Expert:

Dr. Chris William Sanchirico

Professor of Law, Business and Public Policy

University of Pennsylvania Law School and Wharton School

Credentials:

Is co-director of Penn's Center for Tax Law and Policy.

Author of "The Tax Advantage to Paying Private Equity Fund Managers With Profit Shares: What is it? Why is it Bad?" (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=996665).

Holds a law degree and a Ph.D. in economics.

Teaches taxation and tax policy at Penn.  

Quotes:

On the mechanics of the tax advantage:  

"When private equity fund managers take their compensation as a share of fund profits rather than as salary, they effectively convert current ordinary income into later capital gains and so pay at a lower rate, at a later date.  What's usually ignored, however, is that the fund's investors generally suffer the reverse conversion.  They forego an ordinary deduction for the fund managers' salary in return for lower capital gains income down the road because the deduction would have lowered their basis.  If investors and managers are in the same tax position, there is no net tax advantage to paying managers with a share of fund profits and probably no real tax advantage for the managers taken alone, as investors can be expected to demand lower fees to compensate for their higher taxes.  The tax advantage for carried interest, therefore, turns on the differing tax positions of fund investors and fund managers, a fact which helps explain the prevalence of tax exempt investors."

On the propriety of the tax advantage:   

"Elsewhere in the economy, those who contribute labor and expertise to a business enterprise generally pay tax on their compensation at ordinary income rates.  The private equity fund manager, however, pays tax at capital gains rates.  In explaining what is wrong with this state of affairs, commentators are apt to hold these two cases out, one in each hand, and ask rhetorically why one form of labor receives more favorable tax treatment than another.  If only these commentators had a third hand, their analysis would be arguably more complete and certainly more complex.  Their third hand would hold those who contribute to the business enterprise not their labor but their capital and who in return for that contribution receive capital gains treatment as a matter of course.  To make the point even more starkly, the third hand might hold those who inherited (tax free) the capital that they now invest."