Editorial: Now, Eric Schneiderman takes on equity funds
The latest questionable doings to draw his attention are the tax tactics of private equity funds, which are partnerships that invest other people's money, often making focused bets on turnaround situations. Schneiderman has subpoenaed documents from at least a dozen such firms with a focus on whether their partners converted management fees into investment returns in ways that impermissibly lowered their New York State taxes. Among the firms is Bain Capital, founded by Republican presidential candidate Mitt Romney, whose representatives have said he didn't use the controversial tax strategy.
As is often the case, Schneiderman, a Democrat, is wading into politically charged waters. And he's already got a lot going on. He's busy investigating the nation's big banks on several fronts, including for alleged foreclosure abuses, potential wrongdoing in bundling home loans into securities, and possibly rigging the benchmark interest rate known as LIBOR. He's also probing the tax-exempt political organizations spending big money on this year's presidential campaign.
New York's top cop is nothing if not ambitious. Yet in each instance he's delved into an unduly neglected situation that practically cried out for someone to investigate. Schneiderman, at least, is willing to dive in.
The tax practices of private equity firms have long generated debate, but the Internal Revenue Service has done nothing to stop the conversion of fees into tax-preferred capital gains. Not all private equity firms do this, but those that do can point to years of IRS inaction as a kind of assent, if not quite a blessing.
Private equity firms enjoy two kinds of compensation: a share of investment profits typically around 20 percent, and a management fee of around 2 percent of assets. According to well-established rules, the profits are considered "carried interest" and taxed as capital gains. That's great for partners because capital gains are federally taxed at 15 percent, instead of the top rate of 35 percent levied on ordinary income. But in addition, some private equity firms have found ways to convert their fees into capital gains as well. Although New York taxes capital gains as ordinary income, Schneiderman is said to be probing whether the firms wrongly deferred fee income or avoided state taxes that should have been paid.
Whatever the outcome, this particular tax feature is emblematic of nearly everything wrong with our nation's atrocious income tax system: It's far too complicated, the law is murky, and it unduly favors people with a great deal of money. A lot of the complexity and controversy would vanish if investment gains and ordinary income were taxed by Uncle Sam at the same rates, as they once were.
Whether Schneiderman finds state-level wrongdoing here, federal law should be changed to eliminate the fee-conversion trick. Private equity firms don't need any more tax breaks. Meanwhile, the attorney general will need all his dexterity to manage the many fish he now has to fry -- and make something more of them than mere headlines.