US Senate legislation targets PE partnership tax structure

Blackstone Partnership Structure Targeted by Senate (Update3)
By Ryan J. Donmoyer

June 14 (Bloomberg) -- Senate legislation would force Blackstone Group LP and Fortress Investment Group LLC to pay taxes as corporations instead of as partnerships beginning in 2012, a move that may threaten Blackstone's initial public offering later this month.

The U.S. Senate Finance Committee introduced legislation today to prevent hedge fund and private-equity firms from using a 20-year-old tax provision that allows investors in publicly traded partnerships to pay capital gains taxes of 15 percent on income distributions. Companies pay a tax rate of as much as 35 percent.

The measure would give New York-based Blackstone and Fortress five years before being required to pay the higher tax rate. It also aims to prevent rival firms such as Carlyle Group and Apollo Management LP from copying the strategy.

``If a publicly traded partnership makes its money by providing financial services, that active business should be taxed as a corporation,'' said Finance Committee Chairman Max Baucus, a Montana Democrat.

The Senate measure, released ahead of Blackstone's $4.75 billion initial public offering scheduled for the week of June 25, is the first major foray by the committee into overhauling tax laws that affect hedge fund and private-equity firms after months of study.

`Crossing the Line'
``Right now, some businesses are crossing the line between reasonably lowering their tax burdens and pretending to be something they're not to avoid most, if not all, corporate taxes,'' said Iowa Senator Charles Grassley, the top Republican on the panel.

Blackstone Chairman Stephen Schwarzman, who may receive as much as $449.2 million for selling some of his holdings in the IPO, interrupted an awards acceptance speech at the New York Stock Exchange to acknowledge the Senate bill.

``We're having an interesting time with this IPO,'' said Schwarzman, who was receiving the Legend in Leadership Award from the Yale Chief Executive Leadership Institute at about the same time the Finance Committee introduced the legislation. ``There's some concern in Congress this is not an ideal thing for companies like us to do.''

Rangel Backs Measure
House Ways and Means Committee Chairman Charles Rangel, a New York Democrat, voiced support for the measure.

``The Ways and Means Committee intends to follow the legislation in the Senate with its own thorough examination of these issues,'' Rangel said.

Alex Brill, a former senior adviser to then-House Ways and Means Committee Chairman Bill Thomas last year, said Congress is likely to adopt some form of the Finance Committee's proposal.

``There are a lot of people who are concerned about this in both parties,'' said Brill, now a research fellow at the American Enterprise Institute, a Washington research organization. ``I put the odds on them cracking down on it.''

Blackstone, manager of the world's second-largest buyout fund, plans to go public after taking part in $199 billion of deals in the past 20 years. The firm, which started with $400,000, was projected to have a market value of $32.4 billion if shares sold for $30, with 12.3 percent of the stock held by the public and China's state investment company buying a 9.7 percent stake in a private transaction.

SEC Filing
Blackstone spokesman John Ford declined to comment. Lilly Donohue, a spokeswoman for Fortress, which began selling shares to the public in February, didn't return a call seeking a comment. In filings with the Securities and Exchange Commission that warned of potential congressional action, Blackstone said such legislation would reduce the value of its stock at the offering.

``If any such legislative proposal were to be introduced having terms that would apply to us, were to survive the legislative and executive process in that form and were to be enacted into law, we would incur a material increase in our tax liability and a reduction in the value of our common units,'' Blackstone said in a June 11 filing.

``It's great that Congress is announcing its intentions now, before the IPO, so investors can appropriately discount the price of the shares to reflect the tax risk,'' said Victor Fleischer, a University of Illinois law professor who is advising the Finance Committee on the tax treatment of hedge fund and private-equity firms.

Avoid Corporate Rate
Organizing as a limited partnership would allow Blackstone to avoid the 35 percent corporate tax rate on most of its income. Instead, shareholders and executives would pay taxes at the 15 percent capital gains rate on distributions.

The strategy mimics one adopted by Fortress, a private- equity and hedge-fund manager that went public Feb. 8. It hinges on the use of a 1987 exception in the tax code that offers favorable treatment to publicly traded partnerships that earn more than 90 percent of their income from passive investments, including interest, dividends, and capital gains.

Under the proposed Senate measure, Fortress would have to pay taxes at the corporate rate beginning in 2012, said Finance Committee spokeswoman Carol Guthrie.

Actively operated businesses -- those that produce goods and services -- are taxed as corporations before distributions are made to shareholders as dividends. Partnership income flows directly to shareholders without intermediary taxation. The shareholders are then taxed at individual rates.

REIT Treatment
The transaction Blackstone plans compares with the tax treatment of real estate investment trusts, most of which have publicly traded shares but are predominately passive investment vehicles.

About half of Blackstone's income comes from so-called carried interest, or the 20 percent share of profits paid to fund managers who are taxed at capital gains rates, filings said.

``Our existing owners who are individuals were generally taxed at a maximum U.S. federal income tax rate of 15 percent,'' the filing said.
Fleischer said allowing Blackstone to organize as a partnership would give it an unfair advantage over investment banks such as Goldman Sachs Group Inc. and Morgan Stanley, which do similar work but are taxed as companies.

``It's hard to see why Blackstone should get a break on corporate taxes when other firms don't, simply because Blackstone makes most of its income in the form of tax- advantaged carried-interest distributions,'' Fleischer said.

Rubin Comments
The Finance Committee also has been studying whether to increase taxes on carried interest, the share of profits earned by fund managers. Former Treasury Secretary Robert Rubin this week said many fund managers should pay taxes at ordinary rates as high as 35 percent because they perform services more than risk their own capital.

House Speaker Nancy Pelosi called Rubin's proposal to raise taxes on fund managers ``interesting.'' On tax matters, Pelosi defers ``to our distinguished chairman, Mr. Rangel, and what he wants to do is put everything on the table,'' she said in an interview on Bloomberg Television's ``Political Capital with Al Hunt.''

While Baucus said last month that he's ``nowhere close'' to having legislation that would raise taxes on managers' pay, industry experts say Rubin's remarks will increase pressure on Democrats who control Congress to act.

``I think it makes it almost inevitable,'' said Steven Howard, a partner at the New York law firm Thacher Proffitt & Wood LLP who has been advising investment firms for 25 years. ``I think it will have a major impact on the way Congress views this study.''