Private-equity managers are bracing for higher taxes in 2013 and in the final weeks of this year are refinancing investments, accelerating gains and shifting what they transfer to trusts.
Top earners face higher taxes on wages, investments and money transferred to heirs starting next year because of tax cuts set to expire and new taxes for high-income Americans from the health-care law. Executives in the private-equity industry also may see taxes rise on their share of profits in buyout deals -- known as carried interest -- as Congress looks to raise revenue though an overhaul of the U.S. tax code.
“They’re economics first,” Sandy Presant, an attorney at Greenberg Traurig LLP in Los Angeles said of his clients who are private-equity managers. “They’re going to want to cash in by year end.”
About 90 percent of clients already have used the current generous exemption for non-taxable gifts, said David Wilfert, a wealth adviser in the group serving private-equity managers at New York-based JPMorgan Chase & Co.’s (JPM:US) private bank. “This client base has been extremely focused on using their $5.12 million exemption,” said Wilfert, who is also a managing director.
Legislation enacted in 2010 raised the lifetime estate-and- gift tax exclusion for 2011 and 2012. The opportunity for individuals to transfer as much as $5.12 million -- or $10.24 million for married couples -- free of estate taxes and gift taxes is set to expire Jan. 1 and drop to $1 million for 2013.
Congress returns to Washington this week with about a month until the current estate and gift tax rules expire. Those taxes may be addressed as part of negotiations over the so-called fiscal cliff, or $607 billion of tax increases and federal spending cuts set to kick in automatically in January. Republicans and Democrats disagree on what to do to avert the tax and spending changes.
Private-equity managers’ gifts to relatives typically include a low-valued “vertical slice” of their general partner interest in a fund, which includes a piece of their carried interest, Wilfert said. That way, if the investment does well, it would appreciate in a trust free of estate and gift taxes.
Today, with the risk of the exemption shrinking, clients are taking an opposite approach. To reach that ceiling and place assets into trusts before Dec. 31, he said, they are using cash, securities or real estate.
One strategy is to set up the trusts as so-called grantor trusts, said Hunter Payne, partner and general counsel at Harbour Capital Advisors in McLean, Virginia. Those types of trusts often allow the creators to swap initial assets for ones of equal value later, such as investments in a family partnership that’s funded with proportionate shares of private- equity fund interests, Payne said.
This year’s presidential campaign focused attention on the taxation of private-equity managers as Republican nominee Mitt Romney, the former chief executive officer of Bain Capital LLC, built his wealth in the industry. Romney’s 2011 tax return showed he paid a 14.1 percent federal tax rate on $13.7 million of income because much of his income was taxed at preferential rates.
Carried interest is often taxed as capital gains. The top rate on long-term capital gains, now 15 percent, is lower than levies on ordinary income such as wages. The rate is set to rise to 20 percent in 2013. High earners will face an additional 3.8 percent tax on investment income as a result of the 2010 health care law.
Democrats including Representative Sander Levin of Michigan, the top Democrat on the House Ways and Means Committee, for five years have been seeking to tax carried interest as ordinary income. President Barack Obama’s most recent budget also proposes the change, which according to the Joint Committee on Taxation would raise $16.8 billion over the next decade.
Heads of private-equity firms including David Rubenstein, who co-founded the buyout firm Carlyle Group LP (CG:US), indicated this month they expect carried interest to be among the tax breaks that Congress will scrutinize in tax-overhaul discussions.
“Carried-interest taxation and a great variety of other issues will no doubt be addressed,” Rubenstein said Nov. 8.
George Roberts, who runs the private-equity firm KKR & Co. with his cousin Henry Kravis, said on Nov. 14 that “it would be good to look at everything in the tax code” to make it simpler and fairer.
Private-equity managers are preparing for changes to the tax treatment of their share of profits, said Jim Brown, a partner in the tax group at New York-based Willkie Farr & Gallagher LLP. Some are considering whether to accelerate gains on accrued carried interest at current tax rates. One way to do that is by transferring general partner interests to an affiliate in a taxable transaction, Brown said.
“The idea of the strategy is to do something that accelerates the gain” on the general partner’s share of the underlying assets, Brown said. Once that gain is recognized, whatever’s left can be protected from the higher rates, he said.
The affiliate is usually set up as an S Corporation or a non-U.S. firm based in a place like the Cayman Islands so it isn’t subject to corporate-level U.S. tax, he said. Taxpayers should make sure to follow IRS rules when setting one up, he said.
Private-equity executives also are restructuring funds in anticipation of changes to the taxation of carried interest, said Presant of Greenberg Traurig, who is chair of the firm’s real estate fund practice. Some are refinancing loans that partners made to other employees to invest in deals, getting them instead from third parties such as banks, Presant said.
That’s because the proposals in Congress have allowed so- called qualified capital, or investments that managers make alongside investors in a deal, to still be taxed at preferential rates. If those investments are borrowed from a firm’s partners, they wouldn’t count as qualified capital and would be subject to higher rates, he said.
With or without legislation to change the taxation of carried interest, private-equity managers face will face higher taxes next year, said Patrick Cox, partner and tax chair at Brown Rudnick LLP in New York. That’s why some are looking at accelerating sales of assets such as real estate or trying to close deals on investments before year end to take advantage of current rates, he said.
“If you identify property that you may sell in the next few years, you probably want to race to sell it because you could reinvest the tax savings,” Cox said.
The potential to close deals -- particularly in real estate -- while prices and tax rates are attractive is driving managers to act in 2012, Presant said.
“It’s a perfect storm for people to sell,” he said. “I get my carried interest at capital gains rates, for sure. I get a high price for the property. And capital gains rates are at all-time low.”
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