Private Equity Tax Practices Face Scrutiny

Sep 4 2012 | 10:21am ET

New York's two previous attorneys general have been thorns in the side of Wall Street, and the office's current occupant is proving no different.

Eric Schneiderman's office is investigating whether private equity firms are improperly using two controversial methods to reduce, delay or avoid paying some taxes. Among the firms potentially in the crosshairs is Bain Capital, the p.e. shop founded by Republican presidential candidate Mitt Romney.

At issue are several practices. In fee-waiver conversions, private equity firms or managers waive management fees, instead having investors put the saved money into a firm's fund. The move turns management fees, usually taxed as ordinary income, into capital-gains, taxed at less than half the ordinary rate. Schneiderman's office is also looking into whether some firms have claimed that such income wasn't income at all, but return of capital, which would be entirely untaxed.

Several firms, including Bain, have utilized fee-waiver conversions. No firms are known to have employed the latter tactic. But even fee-waiver conversions are controversial in the academy and in the industry, where some top firms, including the Blackstone Group and the Carlyle Group, have never used them.

Still, the Internal Revenue Service has not taken issue with the conversions, which Steve Judge of the Private Equity Growth Capital Council called "legal, widely-recognized and often part of negotiated agreements between the alternative investment community and investors." The IRS did look into them, calling conversions an area of "possible noncompliance," but appears to have taken no action.

Some have questioned Schneiderman's motivations, noting that the Democrat launched the investigation at the same time that the matter became an issue in the press and the presidential campaign. But his office has said that the probe emerged from a newly-created taxpayer protection unit and that it subpoenaed 13 firms in July, before the issue broke.

In addition to Bain, New York has subpoenaed Apollo Global Management, Clayton Dubilier & Rice, Crestview Partners, H.I.G. Capital, Kohlberg Kravis Roberts, Providence Equity Partners, Silver Lake Partners, Sun Capital Partners, TPG Capital and Vestar Capital Partners. And a 2009 Dow Jones survey showed 40% of buyout firms have employed the practice. For his part, Romney has denied ever using conversions to cut his tax bill.

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