Do private equity firms owe regular income tax?

For a decade, Congress has been debating how to tax managers of private equity firms. The argument is pretty familiar to tax wonks: Should these partners treat this compensation (commonly called carried interest) as capital gains, as they do today? Or should they be taxed at the higher ordinary income rate as President Obama and others have urged?

But what if the predicate of the debate is wrong? What if the returns to private equity firms themselves, as well as their managers, are already ordinary income under current law? What if the IRS has been getting it wrong all these years to the great benefit of private equity funds and similar investment firms?

That’s the provocative argument my Tax Policy Center colleague Steve Rosenthal made in a paper earlier this year. Last month, Steve, who has had a long career as a tax lawyer, debated his theory with Andrew Needham, a partner at Cravath, Swain & Moore and a well-known expert in the tax treatment of these firms.

An edited version of their debate, before the American Bar Assn. national tax section, was reprinted by our friends at Tax Notes who have kindly made it publicly available. The legal arguments get pretty technical but they come down to this:

Steve argues these firms earn their profits in the course of a trade or business (which is roughly buying underperforming or start-up companies, improving their management, and reselling them at a profit). Thus, as with any firm that develops property as part of its trade or business, their returns should be taxed as ordinary income. Sure, they invest a large amount of capital, but they should be treated just as any other firm that puts labor and capital into its business in an effort to earn a return.

By contrast, Mr. Needham argues that these firms and their managers are merely passive investors, and not operators of the companies they buy. Thus, their profits should enjoy the low-rate tax treatment of capital gains.

It is a fascinating debate with important consequences for investment firms as well as the fisc. You don’t need to be a lawyer to enjoy it.