What Carlyle and Bain Capital can teach us about taxes

The on-again, off-again battle over how to tax the compensation of private equity managers may be on again, thanks to the confluence of two seemingly unrelated events.

The first is the controversy over the role of Bain Capital, the investment partnership whose founders included Republican presidential hopeful Mitt Romney. The second is the disclosure by another firm, The Carlyle Group, of how its top executives are compensated.

Both have heightened the focus on what these outfits do and how they are taxed. Bain and Romney, of course, have come under withering criticism from Newt Gingrich and Rick Perry who allege the firm’s investment strategy has led to reams of pink slips at companies it acquired.

That story is much more complicated than Romney’s opponents suggest. Nonetheless, it has lots of people thinking about what private equity does.  

Also this week, Carlyle disclosed its executive compensation in some detail, providing a rare glimpse into how investment firm managers are paid. Combined with the Bain flap, it will surely reopen the five-year old debate over the special tax treatment these partnerships receive through a mechanism known as carried interest or, in short, “the carry.”

The carry allows general partners in investment deals to receive compensation in the form of tax-advantaged capital gains, which are taxed at 15 percent, rather than as salary, which would be taxed as ordinary income with a top rate of 35 percent. This happens because the managers are paid with a fee (up to 2 percent) plus 20 percent or more of their investor’s profits. Those profits are taxed as capital gains even though the general partners may have little or no money of their own at risk in the deal.

Carlyle’s disclosure opens a small window into how this works. In 2011, its three founders were each paid about $140 million. But they received just $275,000 in salary and another $3.5 million in the form of a bonus (also taxable at ordinary income rates). But each also got $134 million—or 96 percent of their compensation–from investment profits. Much came from the carry and is taxable at 15 percent.

It is difficult to know exactly how much of that compensation was performance-based and how much came from fees. But if all of it were taxed as capital gains, and assuming the partners pay at the top ordinary income rate of 35 percent, they’d each save $27 million.         

The story gets more complicated thanks to the reason why Carlyle disclosed the compensation of its founders. It did not do so, it is fair to say, with enthusiasm. But disclosure is the price the firm’s owners must pay to go public, which is their intention.

That raises the high-stakes question of how to tax the proceeds from the sale of a partnership interest in one of these firms.  This would apply where the entire partnership dissolves, as Carlyle soon will. It may also apply when an individual partner in a firm, such as Romney, cashes out. The New York Times reports that Romney continues to receive a share of investment profits from Bain, although he retired almost 13 years ago.

Should these profits be taxed as capital gains, ordinary income, or some of each? Legislation kicking around Capitol Hill takes the last approach, although different bills use different formulas. Carlyle may want to go public under current law to avoid what could well be a higher tax bill if Congress ever cracks down on the carry.      

This week’s news may make that more likely, especially since lawmakers are scrambling to find revenue to pay for efforts to extend both last year’s payroll tax cut and four dozen other expiring tax breaks. On the other hand, Congress has been trying for five years to address what seems to be an obvious inequity in the law and has gotten nowhere.