There were two weeks left in the Trump administration when the Treasury Department handed down a set of rules governing an obscure corner of the tax code.
Overseen by a senior Treasury official whose previous job involved helping the wealthy avoid taxes, the new regulations represented a major victory for private equity firms. They ensured that executives in the $4.5 trillion industry, whose leaders often measure their yearly pay in eight or nine figures, could avoid paying hundreds of millions in taxes.
The rules were approved on Jan. 5, the day before the riot at the U.S. Capitol. Hardly anyone noticed.
The Trump administration’s farewell gift to the buyout industry was part of a pattern that has spanned Republican and Democratic presidencies and Congresses: Private equity has conquered the American tax system.
one recent estimate, the United States loses $75 billion a year from investors in partnerships failing to report their income accurately — at least some of which would probably be recovered if the I.R.S. conducted more audits. That’s enough to roughly double annual federal spending on education.
It is also a dramatic understatement of the true cost. It doesn’t include the ever-changing array of maneuvers — often skating the edge of the law — that private equity firms have devised to help their managers avoid income taxes on the roughly $120 billion the industry pays its executives each year.
Private equity’s ability to vanquish the I.R.S., Treasury and Congress goes a long way toward explaining the deep inequities in the U.S. tax system. When it comes to bankrolling the federal government, the richest of America’s rich — many of them hailing from the private equity industry — play by an entirely different set of rules than everyone else.
The result is that men like Blackstone Group’s chief executive, Stephen A. Schwarzman, who earned more than $610 million last year, can pay federal taxes at rates similar to the average American.
Lawmakers have periodically tried to force private equity to pay more, and the Biden administration has proposed a series of reforms, including enlarging the I.R.S.’s enforcement budget and closing loopholes. The push for reform gained new momentum after ProPublica’s recent revelation that some of America’s richest men paid little or no federal taxes.
nearly $600 million in campaign contributions over the last decade, has repeatedly derailed past efforts to increase its tax burden.
Taylor Swift’s back music catalog.
The industry makes money in two main ways. Firms typically charge their investors a management fee of 2 percent of their assets. And they keep 20 percent of future profits that their investments generate.
That slice of future profits is known as “carried interest.” The term dates at least to the Renaissance. Italian ship captains were compensated in part with an interest in whatever profits were realized on the cargo they carried.
The I.R.S. has long allowed the industry to treat the money it makes from carried interests as capital gains, rather than as ordinary income.
article highlighting the inequity of the tax treatment. It prompted lawmakers from both parties to try to close the so-called carried interest loophole. The on-again, off-again campaign has continued ever since.
Whenever legislation gathers momentum, the private equity industry — joined by real estate, venture capital and other sectors that rely on partnerships — has pumped up campaign contributions and dispatched top executives to Capitol Hill. One bill after another has died, generally without a vote.
An Unexpected Email
One day in 2011, Gregg Polsky, then a professor of tax law at the University of North Carolina, received an out-of-the-blue email. It was from a lawyer for a former private equity executive. The executive had filed a whistle-blower claim with the I.R.S. alleging that their old firm was using illegal tactics to avoid taxes.
The whistle-blower wanted Mr. Polsky’s advice.
Mr. Polsky had previously served as the I.R.S.’s “professor in residence,” and in that role he had developed an expertise in how private equity firms’ vast profits were taxed. Back in academia, he had published a research paper detailing a little-known but pervasive industry tax-dodging technique.
$89 billion in private equity assets — as being “abusive” and a “thinly disguised way of paying the management company its quarterly paycheck.”
Apollo said in a statement that the company stopped using fee waivers in 2012 and is “not aware of any I.R.S. inquiries involving the firm’s use of fee waivers.”
floated the idea of cracking down on carried interest.
Private equity firms mobilized. Blackstone’s lobbying spending increased by nearly a third that year, to $8.5 million. (Matt Anderson, a Blackstone spokesman, said the company’s senior executives “are among the largest individual taxpayers in the country.” He wouldn’t disclose Mr. Schwarzman’s tax rate but said the firm never used fee waivers.)
Lawmakers got cold feet. The initiative fizzled.
In 2015, the Obama administration took a more modest approach. The Treasury Department issued regulations that barred certain types of especially aggressive fee waivers.
But by spelling that out, the new rules codified the legitimacy of fee waivers in general, which until that point many experts had viewed as abusive on their face.
So did his predecessor in the Obama administration, Timothy F. Geithner.
Inside the I.R.S. — which lost about one-third of its agents and officers from 2008 to 2018 — many viewed private equity’s webs of interlocking partnerships as designed to befuddle auditors and dodge taxes.
One I.R.S. agent complained that “income is pushed down so many tiers, you are never able to find out where the real problems or duplication of deductions exist,” according to a U.S. Government Accountability Office investigation of partnerships in 2014. Another agent said the purpose of large partnerships seemed to be making “it difficult to identify income sources and tax shelters.”
The Times reviewed 10 years of annual reports filed by the five largest publicly traded private equity firms. They contained no trace of the firms ever having to pay the I.R.S. extra money, and they referred to only minor audits that they said were unlikely to affect their finances.
Current and former I.R.S. officials said in interviews that such audits generally involved issues like firms’ accounting for travel costs, rather than major reckonings over their taxable profits. The officials said they were unaware of any recent significant audits of private equity firms.
No Money Owed
For a while, it looked as if there would be an exception to this general rule: the I.R.S.’s reviews of the fee waivers spurred by the whistle-blower claims. But it soon became clear that the effort lacked teeth.
Kat Gregor, a tax lawyer at the law firm Ropes & Gray, said the I.R.S. had challenged fee waivers used by four of her clients, whom she wouldn’t identify. The auditors struck her as untrained in the thicket of tax laws governing partnerships.
“It’s the equivalent of picking someone who was used to conducting an interview in English and tell them to go do it in Spanish,” Ms. Gregor said.
The audits of her clients wrapped up in late 2019. None owed any money.
The Mnuchin Compromise
As a presidential candidate, Mr. Trump vowed to “eliminate the carried interest deduction, well-known deduction, and other special-interest loopholes that have been so good for Wall Street investors, and for people like me, but unfair to American workers.”
wanted to close the loophole, congressional Republicans resisted. Instead, they embraced a much milder measure: requiring private equity officials to hold their investments for at least three years before reaping preferential tax treatment on their carried interests. Steven Mnuchin, the Treasury secretary, who had previously run an investment partnership, signed off.
McKinsey, typically holds investments for more than five years. The measure, part of a $1.5 trillion package of tax cuts, was projected to generate $1 billion in revenue over a decade.
credited Mr. Mnuchin, hailing him as “an all-star.”
Mr. Fleischer, who a decade earlier had raised alarms about carried interest, said the measure “was structured by industry to appear to do something while affecting as few as possible.”
Months later, Mr. Callas joined the law and lobbying firm Steptoe & Johnson. The private equity giant Carlyle is one of his biggest clients.
‘The Government Caved’
It took the Treasury Department more than two years to propose rules spelling out the fine print of the 2017 law. The Treasury’s suggested language was strict. One proposal would have empowered I.R.S. auditors to more closely examine internal transactions that private equity firms might use to get around the law’s three-year holding period.
The industry, so happy with the tepid 2017 law, was up in arms over the tough rules the Treasury’s staff was now proposing. In a letter in October 2020, the American Investment Council, led by Drew Maloney, a former aide to Mr. Mnuchin, noted how private equity had invested in hundreds of companies during the coronavirus pandemic and said the Treasury’s overzealous approach would harm the industry.
The rules were the responsibility of Treasury’s top tax official, David Kautter. He previously was the national tax director at EY, formerly Ernst & Young, when the firm was marketing illegal tax shelters that led to a federal criminal investigation and a $123 million settlement. (Mr. Kautter has denied being involved with selling the shelters but has expressed regret about not speaking up about them.)
On his watch at Treasury, the rules under development began getting softer, including when it came to the three-year holding period.
Monte Jackel, a former I.R.S. attorney who worked on the original version of the proposed regulations.
Mr. Mnuchin, back in the private sector, is starting an investment fund that could benefit from his department’s weaker rules.
A Charmed March
Even during the pandemic, the charmed march of private equity continued.
The top five publicly traded firms reported net profits last year of $8.6 billion. They paid their executives $8.3 billion. In addition to Mr. Schwarzman’s $610 million, the co-founders of KKR each made about $90 million, and Apollo’s Leon Black received $211 million, according to Equilar, an executive compensation consulting firm.
now advising clients on techniques to circumvent the three-year holding period.
The most popular is known as a “carry waiver.” It enables private equity managers to hold their carried interests for less than three years without paying higher tax rates. The technique is complicated, but it involves temporarily moving money into other investment vehicles. That provides the industry with greater flexibility to buy and sell things whenever it wants, without triggering a higher tax rate.
Private equity firms don’t broadcast this. But there are clues. In a recent presentation to a Pennsylvania retirement system by Hellman & Friedman, the California private equity giant included a string of disclaimers in small font. The last one flagged the firm’s use of carry waivers.
The Biden administration is negotiating its tax overhaul agenda with Republicans, who have aired advertisements attacking the proposal to increase the I.R.S.’s budget. The White House is already backing down from some of its most ambitious proposals.
Even if the agency’s budget were significantly expanded, veterans of the I.R.S. doubt it would make much difference when it comes to scrutinizing complex partnerships.
“If the I.R.S. started staffing up now, it would take them at least a decade to catch up,” Mr. Jackel said. “They don’t have enough I.R.S. agents with enough knowledge to know what they are looking at. They areso grossly overmatched it’s not funny.”
The Biden administration on Thursday defended its assessment that it could raise $700 billion in revenue by pumping money into the Internal Revenue Service to beef up its enforcement capabilities amid criticism that its projections were overly rosy.
The Treasury Department released a 22-page report laying out the administration’s new “tax compliance agenda,” which is a centerpiece of its plans to pay for a $1.8 trillion infrastructure and jobs proposal. The Biden administration wants to give the I.R.S. $80 billion over the next decade so that it can overhaul its outdated technology and ramp up audits of wealthy taxpayers and corporations.
The Biden administration’s estimates of the return on investment that it could generate from boosting the I.R.S. budget far surpassed projections by the nonpartisan Congressional Budget Office. And John Koskinen, a former I.R.S. commissioner under President Barack Obama and President Donald J. Trump, has suggested that it would be hard for the cash-strapped agency to efficiently spend that much money.
The Treasury Department said that it believes its projections are conservative. Much of the revenue from more rigid enforcement would become evident in the later part of the decade, the report said, but Treasury officials believe that with more enforcement staff and better technology the I.R.S. can chip away at the “tax gap.”
$1 trillion owed to the government is not being collected every year. The Treasury Department estimated on Thursday that in 2019 the tax gap was $584 billion and is on pace to total $7 trillion over the next 10 years.
The Treasury report said that much of the revenue it estimates would come through its “information reporting” rules for financial institutions. This would give the I.R.S. more visibility into corporate accounts to determine how much money they are actually taking in and what should be taxed. The department said it expects that such reporting would be helpful for audits and would serve as a deterrent against corporate tax evasion.
The new information reporting rules would also include an effort by the Biden administration to bring cryptocurrencies into the tax regime and to crack down on those using cryptocurrencies to avoid paying taxes. The report said that cryptocurrency exchange accounts and payment accounts that accept them would fall under the reporting rules. Businesses that receive cryptoassets with a fair market value of more than $10,000 would be subject to information reporting.
The Biden administration has faced questions from Republican lawmakers, such as Senator Mike Crapo of Idaho, to justify its claims that giving the I.R.S. so much money will yield such robust returns. Conservative political groups have criticized the Biden administration plan to hire an army of I.R.S. agents, saying it’s a way to hike taxes.
The Treasury report attempted to rebut such claims, noting that increased audits would be focused on the rich.
“It is important to note that the President’s compliance proposals are designed to ameliorate existing inequities by focusing on high-end evasion,” the report said. “Audit rates will not rise relative to recent years for those with less than $400,000 in actual income.”
The United States is losing approximately $1 trillion in unpaid taxes every year, Charles Rettig, the Internal Revenue Service commissioner, estimated on Tuesday, arguing that the agency lacks the resources to catch tax cheats.
The so-called tax gap has surged in the last decade. The last official estimate from the I.R.S. was that an average of $441 billion per year went unpaid from 2011 to 2013. Most of the unpaid taxes are the result of evasion by the wealthy and large corporations, Mr. Rettig said.
“We do get outgunned,” Mr. Rettig said during a Senate Finance Committee hearing on the upcoming tax season.
Senator Ron Wyden of Oregon, the Democratic chairman of the committee, called the $1 trillion tax gap a “jaw-dropping figure.”
spending proposal that the Biden administration released last week asked for a 10.4 percent increase above current funding levels for the tax collection agency, to $13.2 billion. The additional money would go toward increased oversight of tax returns of high-income individuals and companies and to improve customer service at the I.R.S.
Taxpayers who already filed their 2020 returns should not amend them to take advantage of tax breaks that were created by the new $1.9 trillion pandemic relief legislation, the Internal Revenue Service commissioner, Charles Rettig, told lawmakers on Thursday, saying that the I.R.S. would automatically send refunds to those who qualify.
Mr. Rettig, speaking at a congressional hearing, was referring to a provision in the law that provides a tax exemption on the first $10,200 of jobless benefits collected in 2020 by unemployed workers whose households earned less than $150,000.
“We believe that we will be able to automatically issue refunds associated with the $10,200,” Mr. Rettig said.
According to The Century Foundation, about 40 million Americans received unemployment insurance last year.
from April 15 to May 17, to give itself and taxpayers more time to handle returns and refunds.
The Treasury Department and the I.R.S. are also racing to develop new regulations and update systems to reflect other aspects of the March relief law.
Treasury officials said at a briefing on Thursday that they are working with the I.R.S. to develop a new online portal to disburse advance payments for the expanded Child Tax Credit, which will provide up to $3,600 per child under age 6 and $3,000 for children ages 6 to 17, regardless of whether a family earns enough to pay income taxes.
The portal will allow taxpayers to upload relevant data for midyear payment adjustments, such as the birth of a child, the officials said.
Treasury officials also said the department is working on additional guidance on how states can use money included in the relief law. That will include clarity about how states must repay relief funds if they decide to cut taxes after receiving aid.