A Biden Win Could Mean a Tax Rewrite for Private Equity

By Chris Cumming

A Joe Biden administration could cause serious pain for private-equity managers' wallets, potentially reversing the gains they have enjoyed from the 2017 tax overhaul.

The Democratic presidential candidate's tax proposal would upend the rules the buyout industry has benefited from for decades and sharply increase the taxation of managers' earnings, tax attorneys and experts say.

The proposals aren't likely to make private equity significantly less appealing to investors, since other asset classes would be subject to the same rules. The private-equity investments of tax-exempt institutions like pension funds and university endowments -- historically, buyout funds' cornerstone investors -- would be minimally affected.

But for private-equity executives themselves, Mr. Biden's proposed change to the capital-gains tax rate would be a financial blow, reducing their take-home profits from selling companies.

"Where you're going to see friction and concern with the private-equity managers is with their carried interest," said Winston Shows, a senior vice president for investment bank Houlihan Lokey Inc. He specializes in tax services related to mergers and acquisitions.

Mr. Biden's tax plan would increase the tax rate on capital gains to 39.6% from the current 20% for people earning more than $1 million a year. For high-earning fund managers, the change would effectively eliminate the treatment of carried interest under a longstanding rule that taxes fund managers' share of investment gains at a lower rate than ordinary income.

The Democrat also has proposed raising the highest individual income-tax rate to 39.6% from 37%, and to add a 12.4% "high earner" payroll tax for Social Security on annual incomes above $400,000, which would be paid half by employer and half by employee. Currently, the payroll tax is capped at annual wages of $137,700.

Taken together, these changes would significantly increase the tax bill for high-earning private-equity managers and firms, said Steven Bortnick, a partner at Troutman Pepper Hamilton Sanders LLP law firm who advises private-equity firms and others on tax issues.

The tax-overhaul measure signed by President Trump in 2017 included several changes private equity opposed, but overall it was widely seen as positive for the industry, reducing the top tax rates for individuals and corporations.

Mr. Trump has said he wants to pass more tax cuts in a second term, though he hasn't offered many details. In August, he said he was considering further reducing the capital-gains rate and lowering income taxes for middle-income families.

Many Democrats, including Mr. Biden, criticized the 2017 tax changes as tilted in favor of business and the wealthy and pledged to roll them back.

Doing so likely would require Democrats to take control of the Senate and the White House while retaining the House of Representatives. Mr. Bortnick said that even if all these wins take place, Mr. Biden would face resistance in implementing his tax plan.

Politicians have taken aim at the carried-interest tax treatment for more than a decade. In the 2016 contest, both Donald Trump and Hillary Clinton pledged to change it, as did Barack Obama when he was a candidate in 2008.

In the face of resistance from lobbyists and businesses, Mr. Biden "may not be able to get [the capital-gains tax rate] all the way where he wants it to be," Mr. Bortnick said.

Attempts to increase the corporate tax rate are similarly likely to be met with broad resistance, including from private equity. The 2017 tax law reduced the top corporate rate to 21% from 35%. Mr. Biden has proposed raising it to 28%.

That change would increase the tax bill for private-equity portfolio companies. It also would present a special challenge for the sector's largest firms, which changed their corporate structure following the 2017 law. Blackstone Group Inc., Carlyle Group Inc., Apollo Global Management Inc., KKR & Co. and Ares Management Corp. all converted to corporations from partnerships, accepting a higher tax bill as the cost of making their stocks simpler to buy and own.

The decision has worked out so well for these firms that it is unlikely a higher corporate rate would cause any regrets, said Patrick Davitt, a partner at Autonomous Research LLP who follows private-equity firms' stocks. Even with a higher tax rate, these firms have seen such a stock-price boost -- with Carlyle, KKR and Apollo joining the Russell indexes -- that a higher tax rate wouldn't outweigh the benefits of changing their corporate structure, he said.

"The lower corporate rate gave them the confidence to do it, but I think the follow-through in terms of the valuation increase they've gotten makes conversion a moot point," Mr. Davitt said.

Blackstone Chief Financial Officer Michael Chae told investors Wednesday that a higher rate would cause "low single digits of additional average earnings dilution over the next several years." He said the firm had taken the possibility of future increases to the corporate rate into account when it decided to convert in 2019.

Write to Chris Cumming at [e-mail]

(END) Dow Jones Newswires

11-03-20 0714ET