In recent weeks, the New York Attorney General, Eric Schneiderman, has subpoenaed more than a dozen of the nation’s largest private equity firms seeking documents to reveal whether they improperly abused a tax strategy to withhold hundreds of millions of dollars from their tax bills.1 Schneiderman’s investigation appears to focus on a specific tax issue concerning the treatment of income from wages, taxed at a top rate of 35 percent, and investments, taxed at 15 percent.
Private equity managers are frequently compensated by receiving a 2 percent management fee, taxed as ordinary income, and a 20 percent share of fund profits, taxed as capital gains at 15 percent. The 2 percent fee is guaranteed income, but managers frequently waive the fee and convert it to income that benefits from the lower tax rate. This waiver and conversion has been defended because of the increased risk to which the income is subject, while critics call this technique a tax loophole.2
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