Finance Weblog: Taxing private equity managers - Instituto de Empresa Business School

Given the aggressive activity displayed by private equity funds and the larger and larger numbers of deals taking place, there are many issues that have attracted the attention of the public regarding this industry. One much discussed issue is the tax bill of private equity managers. A prominent UK private equity manager recently declared in the FT that some managers pay less taxes that the cleaning woman. That was a pretty strong statement. I do not know whether that is true or not, but the comparison could be very illustrative coming from someone within the industry. In the US the congress has recently passed a bill that avoids the possibility much used by managers to consider their compensation as carried interest. The performance fee that is the bulk of their compensation is generally treated as carried interest and taxed at a mere 15 %. The recent bill will not allow this possibility anymore and managers compensation will be taxed at the ordinary top income tax of 35 %. The arguments in favor of the bill can be easily illustrated and are convincing.

First, there is an argument of fairness. How can top income earners have tax brackets that are lower than all taxpayers except those of the lowest income earners?. Second, the current practice has been critized as a deviant application of the law. The equivalence of carried interest with the managers compensation scheme face many caveats. On the one hand, many partners are not investing their own wealth in the many funds that are part of a private equity firm. Hence they are not facing direct loss risk. This loss risk potential would make their compensation fee look like a capital gain, though it is not the case in the private equity industry. On the other hand, private equity managers are not passive managers (which would allow them to defend the concept of carried interest), but actively managing a fund and the compensation fee is the income paid for such activity.

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