25-Percent Cap on Taxes on Pass-Through Income May Mean More Financial Engineering

November 09, 2017

The private equity industry likes to say that it brings operational and financial knowledge to the companies that its PE funds acquire, improves their performance and makes them more valuable, and then sells them for a profit. Rosemary Batt and I, in our book Private Equity at Work: When Wall Street Manages Main Street, document that there are indeed private equity firms that make money by improving the performance of the companies they buy. But most PE funds make money by engaging in financial engineering — loading the companies in their portfolios with excessive amounts of debt to boost returns and get a tax advantage; engaging in aggressive tax avoidance; causing the companies they own to issue junk bonds and use the revenue to pay dividends to their private equity owners; requiring the portfolio companies to pay fees to the PE firm for services they may or may not receive; having the companies sell off real estate or other assets with the proceeds pocketed by the PE firm. In the book, Rose and I proposed policies that would rein in financial engineering and provide incentives for PE firms to focus on operational improvements. Unfortunately, the tax plan introduced in the House by Republican Congressman Kevin Brady goes in the opposite direction and provides new incentives for financial engineering.

We draw on Steve Rosenthal’s excellent analysis of the 25 percent tax rate on partnership income for this example of a new opportunity for financial engineering.

A PE-owned partnership that provides a service and is not eligible for the lower 25 percent cap could still benefit from the tax cut. The partnership could borrow money. It would be able to deduct the interest on the loan at its higher tax rate — as much as 35.22 percent (this bizarre rate is due to the complexities of the Republican tax plan). The partnership could then turn around and invest that money in a real estate investment trust (REIT) — a partnership that invests in malls, office buildings, and so on. A business whose income comes from rent is eligible for the lower 25 percent tax rate, so earnings on the investment in the REIT would be taxed at this rate. Even if the interest on the loan is the same as the earnings from the investment in the REIT, the after-tax income of the PE-owned partnership will be 10 percent higher as a result of these transactions. This is easy money compared with the effort it takes to make operational improvements that raise earnings.

High-priced tax accountants will no doubt find many other opportunities to reduce tax liabilities and increase after-tax income of Wall Street firms and their affiliates. Whatever else happens to employment as a result of this tax cut, there is certain to be more jobs for lawyers.

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