On Saturday, December 1, Stephen Schwarzman — CEO of private equity firm Blackstone Group and noted Trump advisor — hosted a fundraiser at his home for the President. In addition to many of Trump’s wealthy friends, the event was attended by Treasury Secretary Stephen Mnuchin, an advisor to the President on taxes. Not everyone attending the private event, including several leaders of private equity (PE) firms, expressed happiness with the tax bill despite the lopsided share of benefits they will receive. They used the opportunity to lobby the President for tweaks to the Republican tax bill. While we don’t know what the President and his wealthy friends discussed, we do know which provisions in the House and Senate tax proposals have important implications for private equity firms, their executives, and their Limited Partners. Many are favorable to partners in private equity firms and investors in PE funds and will result in substantial tax cuts. Surprisingly, perhaps, given the influential positions of PE moguls in this administration, the tax proposals are not uniformly favorable to the industry.

Along with other businesses in the U.S., private equity firms stand to gain substantial benefits from the reduction of the tax rate on corporate income, from a top marginal rate of 35 percent to a flat 20 percent in both the House and Senate tax proposals (with a 25 percent rate for personal services corporations). This change, if adopted, will cut the taxes paid by companies in PE fund portfolios. Like other taxpayers in high-tax states, however, the executives of PE firms who live in New York, New Jersey, and Connecticut — states with high housing costs, high property taxes, and high state and local taxes — will lose some or all of these deductions. They will face sizable increases in their federal income taxes if either the Senate proposal, which eliminates these deductions entirely, or the House proposal, which repeals the deduction for state and local income taxes and limits the deduction for state and local property taxes, is included in the final bill.

Where Private Equity Wins in Republican Tax Proposals

The partners in private equity firms and funds will benefit from the massive tax giveaway resulting from the reduction in the tax rate on pass-through income in either the House or Senate proposal. The industry has also breathed a collective sigh of relief as the carried interest loophole remains essentially intact despite the President’s promise to close it. There is no change to it in the Senate tax proposal, and the House has proposed a toothless change to the capital gains treatment of a fund manager’s share of fund profits.

Pass-Through Income

Pass-through income refers to the income of individuals from sole proprietorships, partnerships, and S corporations. Unlike ordinary corporations, these business entities pay no income tax. Instead, the net income of the business is passed through to the owners of the business who pay tax on this income at ordinary personal income tax rates. Currently, the top marginal tax rate on personal income is 39.6 percent. Only the wealthiest partnerships, including private equity funds, hedge funds and real estate investment trusts (REITs), are taxed at this rate. These partnerships, and not small businesses, will gain from the changes Republicans have proposed to tax rates on pass-through income.

Both the House and Senate tax proposals would reduce the maximum tax paid by recipients of pass-through income. The rules differ in the two proposals and are complex since some of this income is deemed labor income and taxed at the individual’s income tax rate, while some is deemed to be capital income and is taxed at a lower rate. Income from certain business services — law, accounting and brokerage services, for example, would not be eligible for the reduced tax rate. For eligible individuals (including partners in PE funds and PE firms) in the highest tax bracket, the Senate proposal would reduce the rate from 39.6 percent to a blended top rate of 29.6 percent while the House proposal would reduce it to a blended top rate of 35.22 percent. Management fees collected by active partners of the General Partner (GP) (typically a team of PE firm partners and associates) would not be eligible for the reduced tax rate. Individual partners of a GP (passive partners in the case of the House bill), as well as individual Limited Partners, could benefit from the lower rate on any portfolio company’s business income that flows up to the PE firm.

The Senate bill makes publicly traded PE firms (e.g., Blackstone, Carlyle, KKR, and Apollo) newly eligible for a 23 percent deduction on management fees.

In the Republican tax proposal, real estate investment trusts such as those that the Trump Organization and Kushner Companies partner with will get additional tax breaks not generally available to PE partnerships. But some PE firms that sponsor REITs will benefit. The tax breaks for REITs include a more generous depreciation timetable and a newly granted ability, similar to the carried interest loophole, to pay the lower long-term capital gains tax rate on rental and mortgage interest income.

Carried Interest

The House and Senate proposals on taxing carried interest — the profit share claimed by a PE fund’s General Partner as a bonus for the fund’s good performance — are substantially similar. Efforts to have this income taxed as ordinary income, the same as profit-sharing and performance bonuses in other industries, failed. The House and Senate tax proposals increase the holding period of an asset from its current greater than one year requirement to greater than three years. While this change may affect some hedge funds, it will have very little impact on PE funds. PE funds typically hold most of their investments for more than three years. The latest data on PE exits from companies acquired in a leveraged buyout show that the median holding period has risen to more than six years.

Private Equity Is Not Happy with These Provisions of Republican Tax Plans

Limits on deductions for interest payments in both the House and Senate proposals are likely to hit the private equity industry hard. The new rules do not apply to real estate investment trusts, including REITs sponsored by PE firms. The industry is also concerned that changes in the House proposal to the rules governing income going to some pension plan investors may create a major short-term disruption in the industry and reduction of Limited Partner earnings. Over the longer run, the rule change will raise expenses somewhat and have only a modest effect on LP returns.

Deductions for Interest Payments

Currently, businesses are generally able to deduct all of the interest paid or accrued in the tax year from their tax liabilities. There are two provisions in each of the House and Senate tax proposals that would limit the deduction of net interest expense. The first would disallow deductions for business interest expense that exceeds 30 percent of adjusted taxable income — defined in the House bill as similar to EBITDA (earnings before interest taxes depreciation and amortization) and in the Senate bill as similar to EBIT (earnings before interest and taxes). The House bill is more generous and less restrictive. A limitation on deducting business interest expense will affect the after-tax earnings of companies in a PE fund’s portfolio and their resale value when the fund exits the investments. Limitations on deducting business interest expense do not apply to real estate businesses or REITs.

The second provision limits the tax deduction for business interest expense for a US corporation that is part of an “international financial reporting group.” In the case of private equity, this provision limits the tax deductibility of business interest expense mainly in cases where a corporation has been set up in a tax haven (a “blocker corporation”) to protect foreign investors from having to pay taxes on “effectively connected taxable income” and tax-exempt investors from paying taxes on business income that is not related to its tax-exempt status (“unrelated business taxable income” or UBTI).

Tax-Exempt Limited Partners

Organizations that are exempt from US federal income tax may nevertheless have to pay taxes on unrelated business taxable income (UBTI). Pension plan earnings from investments in private equity funds would qualify as UBTI and would be subject to income taxes even though pension plans are tax-exempt. Under current law, however, state pension plans (and other tax-exempt state and local entities) enjoy a “super” exemption and are not subject to taxes on unrelated business income from direct investments, including investments in private equity funds. The House Proposal repeals this “super” exemption and makes such entities, including state pension plans, subject to the rules on UBTI.

Taxes on unrelated business income can be avoided, however, if a blocker corporation is established in a low-tax haven to collect the UBTI, pay the taxes on it required in that jurisdiction, and distribute the rest as dividends to the tax-exempt organization. Dividends, unlike direct investments, are not considered to be UBTI. If the Republican proposal makes it into the final tax bill, then going forward state pension plans will join other tax-exempt investors in PE funds that establish blocker corporations.

Many state pension plans already invest in PE funds that also include foreign investors subject to tax on so-called effectively connected business income and/or tax-exempt organizations subject to taxation on UBTI. These PE funds already make use of blocker corporations in the Cayman Islands or other tax havens. But for those funds that do not engage in this practice, the potential for disruption arises if existing investments in PE funds are not grandfathered in and investors must either pay tax on UBTI at the 39.6 percent rate or must restructure the investment via the use of blocker vehicles. The Institutional Limited Partners Association argues that it will be impossible to restructure thousands of existing union pension plan investments in private equity by the bill’s start date, instead triggering a 39.6 percent tax rate. This, they argue, would hurt pension plan returns and could discourage further PE investments by public pension plans.

Conclusion

The private equity industry stands to gain from the massive tax cuts in the Republican tax proposals in both the House and Senate bills. But, perhaps surprisingly, despite intense lobbying, they did not manage to hit the ball out of the park. If the provision limiting the tax deductibility of interest remains in the final bill, the PE leveraged buyout business model will undergo significant changes that reduce incentives for overloading Main Street companies acquired by PE funds with debt. This would reduce the returns of PE funds, but would strengthen the finances of the companies they take over. Excessive use of debt increases the risk that portfolio companies will face financial distress or even bankruptcy and liquidation, so this provision would greatly benefit Main Street businesses and their workers.