What is private equity? According to Investopedia, “private equity is composed of funds and investors that directly invest in private companies, or that engage in buyouts of public companies”. This means that a private equity firm puts its money directly into target companies, either companies that are themselves privately owned (like Koch Industries) or ones that sell publicly traded stock (like General Motors and I.B.M.).
The people who run a private equity firm are able to do this because they have vast sums of money, either their own or their partners’ or money they’ve collected from their customers (i.e., investors who pay the private equity firm to manage their money, the same way investors in a mutual fund company pay management fees to the mutual fund company).
Sometimes a private equity firm invests so much in a target company that they control its finances. This allows them to sell the most profitable parts of the target company or saddle it with enormous amounts of debt (I don’t know how, but private equity firms somehow suck profits out of companies they control without ever having to pay back the debt they’ve taken on).
This brings us to an article in The New York Times about how private equity firms avoid taxes, not always legally:
Private equity has conquered the American tax system.
The industry has perfected sleight-of-hand tax-avoidance strategies so aggressive that at least three private equity officials have alerted the Internal Revenue Service to potentially illegal tactics, according to people with direct knowledge of the claims and documents reviewed by The New York Times. The previously unreported whistle-blower claims involved tax dodges at dozens of private equity firms.
But the I.R.S., its staff hollowed out after years of budget cuts, has thrown up its hands when it comes to policing the politically powerful industry.
While intensive examinations of large multinational companies are common, the I.R.S. rarely conducts detailed audits of private equity firms, according to current and former agency officials.
Such audits are “almost nonexistent,” said Michael Desmond, who stepped down this year as the I.R.S.’s chief counsel. The agency “just doesn’t have the resources and expertise.”
One reason they rarely face audits is that private equity firms have deployed vast webs of partnerships to collect their profits. Partnerships do not owe income taxes. Instead, they pass those obligations on to their partners, who can number in the thousands at a large private equity firm. That makes the structures notoriously complicated for auditors to untangle.
Increasingly, the agency doesn’t bother. People earning less than $25,000 are at least three times more likely to be audited than partnerships, whose income flows overwhelmingly to the richest 1 percent of Americans.
The consequences of that imbalance are enormous.
By one recent estimate, the United States loses $75 billion a year from investors in partnerships failing to report their income accurately — at least some of which would probably be recovered if the I.R.S. conducted more audits. That’s enough to roughly double annual federal spending on education.
It is also a dramatic understatement of the true cost. It doesn’t include the ever-changing array of maneuvers — often skating the edge of the law — that private equity firms have devised to help their managers avoid income taxes on the roughly $120 billion the industry pays its executives each year.
Private equity’s ability to vanquish the I.R.S., Treasury and Congress goes a long way toward explaining the deep inequities in the U.S. tax system. When it comes to bankrolling the federal government, the richest of America’s rich — many of them hailing from the private equity industry — play by an entirely different set of rules than everyone else.
The result is that men like Blackstone Group’s chief executive, Stephen A. Schwarzman, who earned more than $610 million last year, can pay federal taxes at rates similar to the average American.
Lawmakers have periodically tried to force private equity to pay more, and the Biden administration has proposed a series of reforms, including enlarging the I.R.S.’s enforcement budget and closing loopholes. . . .
The private equity industry, which has a fleet of almost 200 lobbyists and has doled out nearly $600 million in campaign contributions over the last decade, has repeatedly derailed past efforts to increase its tax burden.
“If you’re a wealthy cheat in a partnership, your odds of getting audited are slightly higher than your odds of getting hit by a meteorite,” Senator Ron Wyden, the committee’s chairman, told Mr. Rettig at the hearing. “For the sake of fairness and for the sake of the budget, it makes a lot more sense to go after cheating by the big guys than focus on working people.”
Yet that is not what the I.R.S. has done.
Private equity firms typically borrow money to buy companies that they see as ripe for turnarounds. Then they cut costs and resell what’s left, often laden with debt. The industry has owned brand-name companies across nearly every industry. Today its prime assets include Staples, Petco, WebMD and Taylor Swift’s back music catalog.
The industry makes money in two main ways. Firms typically charge their investors a management fee of 2 percent of their assets. And they keep 20 percent of future profits that their investments generate.
That slice of future profits is known as “carried interest.” The term dates at least to the Renaissance. Italian ship captains were compensated in part with an interest in whatever profits were realized on the cargo they carried.
The I.R.S. has long allowed the industry to treat the money it makes from carried interest as capital gains, rather than as ordinary income.
For private equity, it is a lucrative distinction. The federal long-term capital gains tax rate is currently 20 percent. The top federal income tax rate is 37 percent.
The loophole is expensive. Victor Fleischer, a University of California, Irvine, law professor, expects it will cost the federal government $130 billion over the next decade.
Back in 2006, Mr. Fleischer published an influential article highlighting the inequity of the tax treatment. It prompted lawmakers from both parties to try to close the so-called carried interest loophole. The on-again, off-again campaign has continued ever since.
Whenever legislation gathers momentum, the private equity industry — joined by real estate, venture capital and other sectors that rely on partnerships — has pumped up campaign contributions and dispatched top executives to Capitol Hill. One bill after another has died, generally without a vote.
There’s much more in the article, including how these guys pretend they aren’t collecting management fees (which are taxable as regular income) by disguising them as capital gains (which are taxed less). But you get the idea.