Carried Interest - A Primer

One of the least-understood proposed tax provisions of the American Jobs Act of 2011 concerns the taxation of “carried interest” of private equity firms.  Is the current tax treatment of carried interest really a tax loophole?  What is a private equity firm?

Private equity firms are limited partnerships that provide a means for the pooled investment of several investors.  A typical structure is a general partner that syndicates the partnership, and several limited partners, usually institutional and wealthy individual investors.  The investment horizon is long-term, typically 10 years.  The general partner performs all necessary research and due diligence to identify qualified acquisitions, while the limited partners provide the funding.  These acquisition targets are typically existing but underfunded or undervalued companies.  The general partner creates value in the acquisition with operational and management expertise as well as requisite funding.  Investments in these targets are typically equity, and the exit strategy is a target IPO or sale of the target to another investor.  The limited partners, by definition, have no control over the management of the partnership.  Their investment is entirely at risk (they may lose it all), and their profit is only realized upon exercise of the exit strategy.

The general partner receives compensation in three ways – salary, performance bonuses, and carried interest.  A more common name for carried interest is “sweat equity”, and is a long-standing tenet of partnership law. The idea is that partners who contribute ideas and talent can participate in equity along with those who contribute only cash.  Upon exercise of the exit strategy, limited partners are paid some hurdle rate of return, say 8%, then remaining gain is typically split, say 20/80, between general and limited partners.  That 20% is the carried interest.  Current law states that the carried interest is a return of investment, and as such is treated as capital gain.  Since the investment is long term, the capital gain is long term.  Currently, the maximum tax rate for long-term capital gains is 15%, whereas the top marginal rate for ordinary income, e.g. salary, is 35%. 

So, general partners in private equity firms are taxed at 35% on salary and bonus, but at only 15% on carried interest.  The current proposal centers on that disparity, and claims that the carried interest is in fact compensation, and should be taxed as such, i.e. at 35%. 

There are several arguments for and against treating carried interest as compensation.  However, current tax law treats carried interest as capital gain.  There are also good arguments (with which I agree) for taxing capital gains at lower rates than ordinary income, but a thorough discussion is beyond the scope of this article.

Most of the arguments in favor of treating carried interest as compensation appear to be emotion-driven.  You need to look no farther than Stephen Schwarzman of private equity firm Blackstone.  Schwarzman is a VERY wealthy individual (and the tax treatment of carried interest has helped to make him so), and is the reigning poster boy for Wall Street excess and conspicuous consumption.  For example, he rented the Armory in NYC for his 60^th birthday party on 2/13/07 which featured a 30 minute private performance by Rod Stewart, who was paid $1M.  Total cost of the party was reportedly $5M.  (Schwarzman also donated $100M to the NY Public Library in 2008, but that didn’t get quite as much press for that.)  On 6/22/07, Schwarzman and partner Peter Peterson took Blackstone public.  Filings with the SEC in connection with the IPO disclosed his income, which at that time was over $1M PER DAY.  Around that same time, a research paper concerning carried interest by an obscure professor, Victor Fleisher, surfaced in the Senate Finance Committee hearings.  It’s no coincidence that Rep. Sander Levin (D-MI) introduced legislation on 6/22/07 to treat carried interest as compensation.  Interestingly, the Treasury Department at that time suggested, both in testimony to Congress and in various speaking engagements, that altering the tax treatment of a single industry raises tax policy concerns and that changing the way partnerships in general are taxed is something that should be done only after careful consideration of the potential impact.

Risk varies with directly reward.  A risk-adverse investor may choose to invest in FDIC-insured CDs, but his reward may be only 1%.  An investor in a private equity fund may have very large upside potential, but could also lose his entire investment. Capital is mobile. Taxing one industry sector at the expense of another may only result in movement of capital without any actual tax benefit. The cost of capital has a tax component that all investors consider.  No change in tax policy should be considered in a vacuum.

Honestly, this entire debate reminds me of Congressional hearings in 1969, where the news of a mere 21 wealthy individuals that paid no income tax at all spurred the creation of the Alternative Minimum Tax.  The root causes were subsequently addressed by legislation, particularly the Tax Reform Act of 1986, but we’re still stuck with the AMT.

By the way, here is a video of a recent appearance of Schwarzman in NC.

Data Analysis on a budget

Warning!  Extreme auditor geek content!  This blog discusses an example of data extraction and analysis software used by auditors, and is probably of little or no interest to the general public.

My audit practice consists entirely of non-profit organizations.  Almost all of these organizations use Quickbooks; the others use or outsource to some other GL software that is exportable to Excel.  In an effort to become as efficient and effective as possible, I use data extraction and analysis software during the course of all audits; specifically in audit planning, risk assessment, and audit procedures in response to that assessment. 

There are a number of software products included under the heading of CAATS (Computer Aided Audit Tools) available for this purpose, including Caseware’s IDEA, ACL, etc.  A Wikipedia article discussing CAATS is here.  As a sole practitioner, cost is a consideration.  Also, due to the size of my NPO audit clients (revenues from $250k to $3M) and volume of transactions, Excel limitations (# of rows, etc.) are never exceeded.  Therefore, I chose ActiveData for Excel, an Excel add-in.  (Disclaimer – I am not an employee or commissioned salesman for ActiveData.  I just use their software.)

In all audits, Quickbooks transaction data is first exported to Excel, and preliminary analysis is performed.  For example, revenue sources and vendors are grouped and summarized, and the top X% are considered, then cut and paste to PPC NPO-CX-3.1.  A quick comparison of vendor address to employee/Board member address is performed.  A comparison of vendor summaries across two periods is performed and considered.  Benford’s Law analysis is performed and considered. If it is determined that internal controls will be relied upon, the ActiveData sampling functionality is used for sample selection and procedure documentation.

Other preliminary tests specific to the client are performed, and serve as input to NPO-CX-7.1 for risk assessment.  Once preliminary risk assessment is complete, ActiveData is again employed in the conduct of the audit.  For example, journal entry analysis in response to PPC NPO-AP-2 #4, search for related party transactions per PPC NPO-AP-2 #10, search for check number gaps, subsequent sampling, etc.

In addition to the familiarity of Excel, ActiveData also has very useful Help functionality, reference materials such as “Top Audit Tests Using ActiveData for Excel” by Michelle Shein and Richard Lanza (which stays in my laptop case at all times), and several YouTube instructional videos.  For example, a video discussing sampling functionality is here, and a video discussing Benford’s Law analysis is here.

ActiveData’s website is here.

Obviously, ActiveData is just one tool in the audit bag.  But, all in all, it’s a lot of functionality for $250!

In Praise of Social Media

A recent article on CNN.com discussed the rapid emergence of women as the current “Power Users” of Social Media.  On average, I think women are far more adept than men in developing and maintaining relationships, so it makes sense to me that they excel at Social Media.

After reading the article, I considered my own use of Social Media.  I use Facebook and LinkedIn regularly, but for two entirely different purposes.  For me, Facebook is for family and friends, and LinkedIn is for business.  Of course, I have business contacts that are also friends, but in general that defines my usage. 

As background, I am a CPA with a small but technically demanding practice.  My two primary practice areas are tax and non-profit audits, including OMB A-133.  Tax season is immediately followed by Audit season, and I average 60 hours/week all year.  I have an administrative assistant, but no professional staff.  If I have a technical question, there is no one down the hall to ask – I have to find the answer myself. There is no depth to my bench.  (I‘ve been a sole practitioner since ’05, with larger firm experience prior to that.  I plan to compare the two in a future blog.)

 

My research resources for tax and audit are very good, but I occasionally get questions from clients outside of my areas of expertise that I simply don’t have an answer for, and don’t have the resources with which to quickly find the answer.  For example, a client recently asked a question involving NC sales tax liability on the disposition of machinery in liquidation.  I had a preliminary answer that made sense to me, but nothing authoritative to cite.  I had an audit deadline looming, zero spare time, and needed a correct answer fast.  What to do?

Over the years, I’ve developed a resource network.  We all have to some extent.  Social Media in general, and LinkedIn in particular, has provided a platform to greatly expand that network.  To that end, I’ve consciously cultivated LinkedIn contacts with “Big 4” and large national and regional accounting firms, attorneys, AICPA technical managers, government officials - people who are experts in their (sometimes VERY specific) field.  To be honest, the vast majority of my LinkedIn contacts are people that I’ve never met.  In LinkedIn, any contact request requires me to indicate how I know the person, e.g. former coworker, classmate, someone I’ve done business with in the past, friend, etc.  There is no choice for “I think you are smarter in your specific area of expertise than I am, and I may need to pick your brain at some point, if that’s OK with you”, so I redefine and click "friend".

So, for all you LinkedIn contacts who have no idea who I am, but accepted the contact request anyway, THANK YOU!  I appreciate your contact very much! Please realize that I think you are the best in your field!  Also, please know that I consider this network of contacts a two way street.  If there is ever anything I can do for you, just ask.

Back to the Sales Tax question.  I emailed the question to a LinkedIn contact, Tony Buffkin.  Tony is Senior Manager with Dixon Hughes Goodman’s State and Local Tax Practice in Charlotte, and is a former KPMG National Technical Leader in the Sales Tax Systems Practice and a former Division Director at NC Department of Revenue.  He is a recognized expert in sales tax (among other things).  Within 10 minutes, Tony responded with the answer, including an authoritative citation.  Problem solved. 

Thanks again, Tony!  And, THANK YOU for accepting me as a LinkedIn contact!