Members of Congress have been calling for raising taxes on the profits of private equity firms and hedge funds, along with taxing the incomes of their top managers at the same rate as managers of corporations.

One of the main drivers has been the IPO of The Blackstone Group, which netted the company $4.75 billion. Some observers worry that the firm will try to avoid paying taxes on the bulk of its gains by attributing a big chunk of that amount to goodwill.

Blackstone, of course, denies that it has any such plans. Blackstone CEO Stephen Schwartzman has also come under fire, as he was one of the main beneficiaries of the IPO, earning $684 million. Like managers of other private equity firms and hedge funds, he is subject to only a 15 percent tax on "carried interest," instead of the 35 percent he would pay if his salary were counted as regular income. That's because managers of these firms pay the rate for capital gains rather than income.

One congressman who is proposing that private equity firms, hedge funds and their managers pay higher taxes is Senate Finance Committee Chairman Max Baucus, D-Mont. At a hearing this month, he complained, "Some hedge fund managers and private equity managers are taking home more than $100 million a year in what is called 'carried interest' income. And much of that income is being taxed at the long-term capital gains rate of 15 percent. They are not paying the higher rate for ordinary income." He and ranking minority member Sen. Chuck Grassley, R-Iowa, have co-sponsored a bill that would require private equity firms and hedge funds that go public to pay corporate taxes.

But the Bush administration warns that raising taxes on these firms and their managers could have a dampening effect on the economy. Eric Solomon, an assistant Treasury secretary for tax policy, said at the same hearing that such a move "may have adverse consequences on entrepreneurial activity."

A study from the advocacy group Citizens for Tax Justice disputes some of the arguments of defenders of the status quo. The group points out that unlike investors who are taxed only on capital gains, fund managers don't invest their own money. They are compensated for their financial expertise by getting a cut of what the investors in the fund put in. If the fund loses money, they can simply walk away without losing money of their own.

Another group, the Economic Policy Institute, estimates that the privileged tax treatment given to managers of private equity firms and hedge funds costs more than $6 billion in lost tax revenue.

Proponents of the hedge funds and private equity firms argue that by raising taxes on their earnings, the firms and their managers will have less incentive to make the spectacular returns they have generated and that will hurt the pension funds and other institutional investors that back them.

But given the outsize returns generated by these firms, it's likely there will still be plenty of incentive for them to keep buying up companies and playing the market, no matter what tax rate they're forced to pay. Pressure is building in Congress, but that's only going to cause the firms to ramp up their lobbying activities to keep the tax laws in place.

Register or login for access to this item and much more

All Accounting Today content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access