The New York Times revealed last week that the Blackstone Group has devised a way for its partners to avoid paying taxes on the bulk of what it raised from its recent IPO. Although Blackstone partners will initially pay $553 million in capital gain taxes, these partners will get back about $200 million more than that over the long term, due to the amortization of goodwill.
Lee Sheppard, a tax lawyer who critiques deals for Tax Notes magazine, has studied the details of the plan. She described how the tax system actually operates at the highest levels of the economy. Ms. Sheppard said, "These guys have figured out how to turn paying taxes into an annuity." She added, "What people don't realize is that the private equity managers, the investment bankers, all the financial intermediaries, are in control of their own taxation, so the debate in Washington about what tax rate to pay misses the big picture."
In other words, Blackstone is a lot smarter than Congress. The Blackstone Group isn't planning to pay any federal taxes at all, no matter what tax rate Congress passes! How can they do that, you ask? It has to do with the fact that when you pay above book value for a business, the buyers incur "goodwill" above a company's book value, so they get to depreciate that goodwill as an expense for many years. This means that private-equity groups can structure their acquisitions so that they incur positive operating cash flow, but post a tax loss due to all the goodwill that they have incurred and are depreciating. So no matter what the federal tax rate is, Blackstone has no intention of paying it. Now you know why they went public, despite threats of higher taxes from the Senate Finance Committee.
Obviously, this revelation (by The New York Times and other news media) about how the private-equity business works is stirring debate about reforming the tax code. The truth is that "goodwill" isn't an accounting trick, since it's been around for decades and isn't likely to go away anytime soon. About all Congress can do is to extend the time frame that Blackstone and others expense goodwill via depreciation. But they will undoubtedly incur massive resistance from all kinds of business interests. Under President Clinton, depreciation was lengthened, but it received stiff opposition from the business lobbies. Other business lobbies, such as those for aviation, were able to obtain favorable depreciation rules for private jets, which have subsequently been reduced by the Bush administration. Depreciation is a very touchy subject and will be hotly debated in the back rooms of Congress, who will be pulling their hair out trying to figure out how to deal with folks that utilize depreciation to avoid taxes. An Alternative Minimum Tax (AMT) on corporations is possible. Although AMT is a very dirty word for millions of middle-class taxpayers, corporations don't vote (they just lobby), so a corporate AMT is possible.
Since we'll be electing a new Congress and president next year, Congress will likely hold hearings and make a lot of noise, but not raise taxes. Republican candidate Rudy Giuliani is proposing a flat income tax, as endorsed by Steve Forbes. Another Republican, Mitt Romney, is calling for flatter, fairer taxes and wants to get rid of all taxes on capital gains, dividends and interest. Obviously, his proposal to abolish taxes on interest will be very appealing to senior citizens that are hurt by up to 35% federal taxes on their interest income. I suspect that Romney will gain ground in the polls since senior citizens are the most powerful voting bloc.
On the Democratic side, I suspect that AMT relief and "fairer" taxes will be proposed. Former Treasury Secretaries Larry Summers and Robert Rubin are already working on new tax proposals that will likely be revealed in time for the Democratic and Republican conventions next year.
