As you all may know, Bain Capital and some other private equity firms are under investigation by the New York Attorney General for tax evasion. Whether the investigation is politically motivated or not,* the legal strategy underlying it was supposedly inspired by this academic tax paper, which does a good job describing the tax avoidance tactic at issue.
To understand how the tax avoidance tactic works you need the following background. Historically, and glossing various accounting issues and niceties of corporate structure, private equity managers have made money in two ways. First, they have been paid a yearly “management fee” of 2% of the total money invested in their fund. Second, they have received “performance-based” compensation of 20% of all gains to the fund calculated over the fund’s entire lifespan. Importantly, the way the performance-based compensation is structured is that management (1) receives 20% of capital gains as calculated on a yearly (or maybe quarterly) basis, but also (2) agrees to a clawback provision that requires management to return money to the general fund if they receive performance-based compensation in excess of 20% of total fund gains (this could happen if early investments are successful but later investments fail).
From the managers’ perspective, this is not the most advantageous tax setup. For federal purposes, while the 20% performance-based compensation, which is compensation that flows from gains on investment capital, is taxed at advantageous capital gains rates (maxing out at 15% or so), as a direct charge for services rendered the 2% management fee is taxed at the higher ordinary income rate (maxing out somewhere in the mid-30% range).
The tax avoidance tactic allegedly deployed by Bain is aimed at getting both of these income streams taxed at the advantageous capital gains rate. The tactic makes two moves. First, the 2% management fee is waived, so no income is paid directly to the fund for services rendered. Second, management provides that it will receive the amount it would have received as a management fee as a “priority allocation” of any capital gains to the fund. The priority allocation differs from the performance-based compensation in that (1) it comes out of the very first slice of capital gains that the fund realizes and (2) it is not subject to any clawback provision. This means that, as long as the fund has enough capital gains at some point during its life to cover what was formerly the 2% management fee, management gets its priority allocation, no strings attached. Assuming that the priority allocation is a “profits interest” (i.e. an interest in future profits generated by the fund) as opposed to direct compensation for services rendered, this tactic succeeds in “converting” the management fee from ordinary income into capital gains. This is because “income from a profits interest is not subject to immediate taxation . . . Instead, income from a profits interest is usually taxed only if and when the partnership realizes the profits that entitle the holder to receive distributions from the partnership. If and when such profits are eventually realized, the character (e.g. capital gain versus ordinary income) of the profits . . . flows through to the holder [of the profit interest].”
The paper I linked runs through various doctrinal arguments for why the priority allocation should be taxed as ordinary income, which I recommend to those interested in the legal details. The basic intuition behind all of these arguments, obviously, is that the priority allocation is a flimsily disguised fee for services rendered, so it should be taxed as a fee for services rendered, and that means taxing it as ordinary income not capital gains.
* It is politically motivated. The NYAG is pretty clearly a party man.