Feeds:
Posts
Comments

Posts Tagged ‘blocker corporation’

In the world of chess being too aggressive at the outset, advancing too far, is perilous. For Romney, his refusal to acknowledge his aggressive financial engineering and tax avoidance strategies could indeed result in an open convention.  One in which the party is free to forward a higher quality candidate.

Here is a list of the facts surrounding the Reid Romney dispute:

1)  On July 20, 2012 I published a blog post noting for the first time that Mitt Romney has not filed the required 990-T form and paid the related UBIT tax with his 2010 tax return, nor has he made this required filing in prior years.   This filing is essential for tax exempt accounts, including IRAs, if they contain related business interests, what I call leveraged transactions in Romney’s case since Bain is an LBO firm.

Remarkably, these 990-T filings are all publicly available by law.  One need only write to the IRS, specify the taxpayer, and within 30 days you will receive a reply if these 990-T filings have been made.   My request regarding Romney applied from 1992-2011, 19 years, and the IRS confirmed none had been filed.

2)  On July 31, 2012 Harry Reid made a claim to the Huffington Post that Romney paid no taxes for more than 10 years.  While Romney may claim that he paid “lots of taxes,” Reid is technically correct in that he has failed to pay taxes on the largest share of his wealth, what is believed to be an IRA worth as much as $100 million, for more than 10 years.

3)  Romney’s only defense is to claim that all his Bain related IRA investments were through foreign blocker corporations, thereby using a loophole that eliminates the need to file the 990-T and pay the required UBIT tax.   Disclosing this of course proves Reid’s claim regarding him paying no taxes, even though he may have used a technically legal scheme.  It is unlikely the public will care that Romney paid other taxes when he has avoided significant required taxes on Bain deals in his largest asset, the IRA.

4)  Worse for Romney would be what is noted in the July 20, 2012 blog post, that being that many of his investments, in particular those in BCIP Trust Associates I and II, were via a Delaware Partnership, not availing him of the foreign blocker exemption.  SEC documents clearly indicate this is the case.  The most recent personal financial disclosure shows BCIP Trust Associates III in his IRA, a foreign blocker, yet previous filings show domestic partnerships.

Even more troubling for Romney would be any transfer of Bain interests from the Delaware based partnerships, non valid blockers, since domestic partnerships are fully subject to UBIT,  to foreign blocker corporations such as BCIP Trust Associates III, after the initial investment, that is re-characterizing the fundamental nature of the partnership.

5)  Prior to 2008 Bain Capital utilized a scheme involving SEP IRAs that allowed employees, including Romney, to invest in Bain deals.  My best guess is that Reid’s office asked someone at Bain to look at the July 20 blog post and they confirmed that while at Bain they also filed no 990-Ts.  What this means, since the SEP is a company sponsored plan,  is that no one likely made the required filing, including Romney.  This simply confirms my original analysis.

Reid therefore stands on sound footing with his claim and the Romney campaign is foolishly self destructing by not coming clean and clarifying the issue.

Romney should step up, say they have a problem and commit to fixing it, but this of course would cost his fellow associates at Bain a bundle in back taxes.

Observing this conflict between Reid and Romney,  Paul Volcker comes to mind.  In particular Volcker’s assertion that engineering belongs in product development, not finance.

Read Full Post »

With all the stories on Romney’s finances, many of which resulted from my observations regarding his tax returns and investment accounts, in particular his IRA, and the interaction of the trusts, foundation and Bain Company filings, the most important story is still untold.

Here it is, the story that could likely open the Republican convention to draft a new candidate.  I have been unsuccessful in getting a major reporter to tell the story, so I guess I’ll just have to tell it myself.

I’ll lay it out in simple steps with no conclusions or opinions.  It is simply astonishing that the media has not told this story.

1)  While head of Bain Capital, Mitt Romney set up a SEP-IRA pension plan that allowed employees to invest in Bain deals.  Mark Maremont of the WSJ did a fine story on this.

2)  IRAs are tax exempt and like other tax exempts must file a special return, a 990-T, if they are invested in leveraged transactions.  This is as straightforward as requiring employers to pay unemployment insurance for employees as part of periodic payroll transactions.  The purpose of the 990-T is to recognize the UBIT or Unrelated Business Income Tax, the rate of which approximates the corporate rate of 35 percent.

Congress adopted this approach for obvious reasons in that if an investor was getting tax exempt income in an IRA, let’s say interest income on a leveraged debt offering, and on the other side of the fence the borrower was taking large interest expense deductions, the net impact would be a double deduction and a grossly dysfunctional tax system.

3) Bain Capital is a leveraged buyout firm in which employees invested in numerous “Bain Deals” via their IRA accounts.  These investments are leveraged and clearly subject to UBIT tax.  Other leading private equity firms do not allow employees to invest in their own deals via IRA accounts.

4)  All 990-T returns, including those relating to IRAs, are by law public.  One need only make a request to the IRS.  In April, I made such a request for Bain and 12 top executives, including Romney, for their SEP IRAs covering the period 1992-2007.  The IRS responded none had been filed.  In addition, I also confirmed no filings were made from 2008-2011 with respect to the new Bain Capital Pension Plan set up by Ropes and Gray in which the official retirement age is 23 (not a misprint).   Maremont of the WSJ also reported on this “unusually young” retirement age.

5)  The only way to escape the 990-T requirement and UBIT tax is to make the investment through a foreign blocker corporation.   Domestic corporations are fully subject to the UBIT and leading law firms are very careful in structuring partnerships to account for this, that is, making sure such investments go through a foreign blocker corporation.

6)  Edgar Online is a public corporation ticker, EDGR, effectively controlled by Bain Capital via a convertible bond issue.  SEC filings clearly indicate this control, summarized in Edgar Online’s executives own words.

Edgar Online is in the business of summarizing  SEC data in user friendly formats that are widely used in the financial and media world.  Many leading databases including Lexis Academic, which is available in most public libraries, use Edgar Online.  One need only search for Mitt Romney using the Lexis Academic database, while specifying a search database of “SEC Filings” from 1/1/2000-12/31/2003 to see a list of references.

7)  In but one example, on February 13, 2000, SMTC Corp, ticker SMTX, filed a 13G report on behalf of Bain Capital.  Under section Item 2a, Name of Filing Person, it specifically states that BCIP Trust Associates II is a Delaware partnership, not a foreign blocker corporation.   This form also states Romney is the sole shareholder of Bain Capital and the only “control person” capable of declaring a special dividend.

8)  ERISA rules require pension plans to be trusts.  For example, if I want to set up a pension plan for Joe’s Consulting with TD Ameritrade, the title for each participant’s account would be Joe’s Consulting Pension Trust FBO followed by the employee name.  For example, Joe’s Consulting Pension Trust FBO Jane Doe would be one employee and Joe’s Consulting Pension Trust FBO Mitt Romney would be another.  The reason is to make absolutely certain each employee’s assets are held in and protected by a separate trust, which is required by ERISA rules.

In Romney’s IRA, note that he is not invested in BCIP Associates II but rather BCIP “Trust ” Associates.  The key word “trust” is a calling card for the IRA.  This can be seen in his recently filed 2012 Personal Financial Disclosure Statement.  Note that the most recent filing shows BCIP Trust Associates III, not II.  Trust III is identified as a foreign blocker in SEC filings yet in previous filings Romney was in Trust II and its predecessor, both domestic Delaware Corporations.

9)  The 13G filing regarding SMTC Corporation on behalf of Bain, referred to in item 7 of this analysis, specifically says BCIP Trust Associates II is a Delaware Corporation, not a foreign blocker.

If this SEC filing is accurate, and it certainly is, then not only Romney, but many other Bain employees have failed to file the required 990-T returns and pay the necessary UBIT tax.   Other leading private equity firms, including KKR and Blackstone, do not allow employees to invest in company deals via retirement accounts for good reason.  Perhaps Bain just got too greedy, consistent with its fees being 50 percent higher than the industry average.

There is a whole cottage industry of law firms that advise tax exempt investors on how to avoid UBIT by using foreign blocker corporations.  These clients include leading endowments such as Harvard and Yale, foundations such as the Gates Foundation and public pensions.

Romney says he trusts his advisors, yet that was clearly a mistake.  They have failed him in not only setting up a valid blind trust, but also a credible investment approach for a Presidential candidate.  See February 22, 2012 blog post for related material and comparison to Bill Esrey, former CEO of Sprint.

More importantly, if these filings made by one of Bain Capital’s portfolio companies, SMTC, and summarized via another entity they effectively control, Edgar Online, are accurate, then Romney is indeed involved in a massive tax fraud and by nature disqualified from being a viable candidate for President.

This is not complicated and hopefully someone will elevate it from the obscurity of a blog to where it belongs, front page top right above the fold on a Sunday.

Read Full Post »

Pulitzer Prize winning reporter and senior editor Mark Maremont of the WSJ wrote the following two stories, explaining how Presidential Candidate Mitt Romney built his IRA to as much as $100 million. Both stories were based upon original Parish & Company analysis.  The purpose of this analysis is not to directly disparage Romney but rather note that his conduct with respect to this scheme is worthy of discussion.

1) Bain Gave Staff Way to Swell IRA’s by Investing in Deals, Wall Street Journal, March 28, 2012

2) Bain Capital’s Unusually Young Retirement Rollover Age of 23, Wall Street Journal, April 2, 2012

The reason these stories are significant is that during Presidential Candidate Mitt Romney’s tenure at Bain, employees were able to use a special scheme, outlined in detail by Maremont of the Wall Street Journal, to put undervalued Bain related partnership investments into their SEP-IRA accounts, thereby going far above annual contribution limits afforded other taxpayers.   Some argue this is aggressive financial engineering while others argue it is outright tax fraud.  At a minimum it certainly has ignited a debate regarding fairness.

When Romney first ran for President in 2008 the law firm that handles his blind trusts, Ropes & Gray, also crafted a new pension plan for Bain Capital. Unlike the previous plan, the new plan allows the firm to hide the same scheme set up by Romney.   The problem is that this appears to be garden variety tax fraud in clear violation of important retirement plan rules.  A fraud enabled by one key provision, an official retirement rollover age of 23.

Bain’s use of an official retirement age of 23 essentially allows all existing employees, each year, to act as if they are doing a retirement related rollover from their profit sharing to IRA accounts outside the ERISA regulatory umbrella.  Of course, if I or most businesses had 23 as an official retirement age the IRS would laugh and shred the plan. (more…)

Read Full Post »

Note (Not Copyrighted) : This basic post was updated December 10, 2010 given the current debate in Congress over extending the Bush tax cuts and numerous inquires regarding my position in this debate.  The purpose of this post is to highlight that although rates are important, perhaps more important are overall fairness issues associated with two situations in particular.  Put another way, why don’t we all forget about the rates and focus on basic fairness first.  Doing that should allow rates to come down in all brackets.

With the financial reform package now passed, all eyes are on the setting of specific rules regarding its implementation.  And while lobbyists attempt to direct the debate away from where it should be, let’s instead visit the core issue, tax rules.

This rollout of specific rules related to the Volcker Rule and related tax considerations will squarely position Paul Volcker, pictured on the lower left below and current IRS commissioner Doug Shulman, lower right, against Blackstone Group LP’s Steve Schwarzman and other leveraged buyout artists operating under the guise of “private equity.”  Why are tax rules key one might ask, especially if these rules have nothing to do with the debate over carried interest?

This is because two specific tax rules have profoundly shaped the current investment markets via a major impact on cash flow. They have also in a more basic fashion functioned as the seeds from which all the other market dysfunctions have originated. The purpose of this post is to briefly explain these two rules and then connect the dots.  Also see related March 31, 2011 post titled Blackstone Tax Engineers, Inspired by GE, attempt to repeal the fractions rule.  This post includes brief audio recordings from leading attorneys and an IRS official regarding the fractions rule.

1)  Net Operating Losses: This involves the practice of creating large pools of net operating loss tax deductions, mostly from unusable technology firms’ stock option deductions when these firms are bought by private equity funds.  These private equity firms then do leveraged buyouts of profitable companies and offset these profitable companies profits into the pool of losses to make the profitable companies tax exempt.

Back in the 1980’s this loophole was intended to be closed when Congress prohibited profitable companies from purchasing such losses and using them all immediately.  The new law required they be amortized over several years.   As former Senate Finance Chair Bob Packwood noted in an Oregonian article, the Treasury never foresaw firms escaping the loophole by using partnerships with large pools of losses to purchase profitable companies.   Essentially, the same transaction in reverse.

Who would think that a partnership whose primary asset were losses would be able to purchase profitable companies. All that was needed in the legislation to prevent this was the term “and vice versa.”  Remarkably, there has been no discussion of this amazing situation, perhaps the biggest tax story in 10 years.

2)  “The Fractions Rule” This rule was put in place at about the same time and designed to prevent tax exempt entities such as public pensions from trading tax deductions they were not entitled to use with taxable partners.  The fractions rule also was designed to discourage tax exempt entities from investing in leveraged buyouts (LBO’s) via partnerships with private equity firms and other taxable partners.   Clearly this would give such firms purchased an unfair marketplace advantage when competing with tax paying businesses.  Or put another way, who would be left to pay tax if all the tax paying firms got gobbled up by partnerships in leveraged buyouts fueled with tax exempt investor funds.

Perhaps one of the nations leading attorney regarding the Fractions Rule, Sanford Presant of GreenburgTaurig, put it best in a 2008 American Bar Association meeting when he said.  “Back then it was tough to get in to our Thursday night committee dinners, they were by invitation only.  Boy was it tough to get in to listen to some of these people and their intelligent pearls.  The real debates were… Can you get 5 to 1 write-offs.  5 to 1?  How do you get 7 to 1!  Everybody was trading on tax benefits and as part of all this backlash, we got the fractions rule.”

Presant is pictured below on the left with Wayne Pressgrove of King and Spaulding on the right.  These two brilliant lawyers represent the leading private equity and hedge funds.

In the ensuing years, once again the industry has attempted to sidestep the fractions rules intent, which applies only to “partnerships,” by using blocker “corporations” set up in the Cayman Islands and other tax havens.  As a trained CPA I find this most disappointing since the IRS rules should be based upon the “substance” of the economic activity rather than the form or structure.  In any event, there is a whole cottage industry of law firms selling advice based upon such  blocker corporation schemes.

A brilliant team of lawyers at King and Spaulding helped write the fractions rule and key to it is the expression “and vice versa.”  This is key because it would prevent the gamesmanship that has occurred with operating losses noted above. Put another way, it would limit allocating deductions from tax exempt to taxable partners in addition to allocating income from taxable partners to tax exempt partners.

What surprises many non tax experts is that these special allocation partnerships can have one set of allocation rules for taxable income and deductions, and a completely different set of rules for cash flow.  The second key aspect of this situation that is creating considerable uneasiness among taxable partners in these partnerships is the rule regarding substantial economic effect, that is, you can’t be simply moving deductions and income between taxable and tax exempt investors unless the transaction has “substantial economic effect.”

This is particularly important with compensation, the numbers of which can be particularly large with private equity and hedge funds.   Large CPA firms now have entire divisions focused upon transfer pricing and expense allocations yet again one has to ask the question, if these transfers do not have underlying economic effect other than moving deductions around, why is this allowed.

It is somewhat ironic that King and Spaulding, the same firm that helped draft the fractions rule, is now leading an effort via the American Bar Association to gut the fractions rule by exempting certain key expenses and transactions.  One recent King and Spaulding partner, Dan Coates, was just elected to the US Senate and expressed interest in being on the Finance Committee, which oversees these rules via the IRS.

We’ve given up on repealing it all together, the ABA notes, and so we are now trying to be more tactical.  This has resulted in the fractions rule becoming what one leading attorney calls the “Mariana Trench” of the Internal Revenue Code.  Perhaps it is also why there has been so little enforcement to date from the IRS,  as noted by Curt Wilson, Associate Chief Counsel in the the office of Passthroughts and Special Industries, at the 2010 ABA Mid Year Tax Section meeting. Wilson noted, I find this surprising especially given the level of angst in industry over compliance with these rules.  See my letter to Wilson opposing granting this revenue ruling.

As an investment advisor I find this remarkable given the current debate over extending the Bush tax cuts.  While smaller LLC based businesses pay federal, state, property and various other forms of taxes and fees, it appears that these private equity and hedge funds are skirting the rules and paying close to nothing.  This of course introduces a significant fairness issue.

Again, the fractions rule specifically limits the trading of tax benefits from tax exempt entities to taxable partners, or vice versa.  Put another way, imagine if you were a taxable partner in a partnership and 90 percent of the other investors were tax exempt entities?  Imagine how difficult it would be to leave 90 percent of valuable tax deductions on the table as unusable?

Perhaps this is why gutting the fractions rule is one of the American Bar Association’s top priorities. (See ABA letter to IRS Commissioner later in this post.)

It could be argued that some private equity firms have become but a sophisticated shell for tax avoidance based upon a maze of interconnected companies and effectively converted to tax exempt status through the aggressive use of net operating loss tax deductions involving executive compensation and transfer pricing.  This has resulted in an unfair competitive advantage against profitable companies that pay taxes.  This has also enraged ordinary small business owners who are not using such schemes.

Investors in profitable companies that actually pay taxes get lower returns than they otherwise would have, making competing with such a scheme on a long term basis difficult.  The situation is even worse for their productive employees who suffer job losses due to takeovers inspired by this scheme, and essential government services which rely on a broad tax base.  This could be the big untold story of the current economic decline, a decline inspired and manufactured by certain private equity firms.  It also explains in large part the constant drumbeat of job outsourcing in that the first thing these private equity firms do is outsource everything off shore possible, no matter the long term consequences.

Again, Congress supposedly foresaw this potential with passage of the “fractions rule”, Internal Revenue Code 514(c)(9)(e) in the late 80’s, to prevent tax exempt entities from trading deductions they cannot use with taxable entities.  One need only examine the growth in tandem of public pensions and private equity investment to see the dimension of this issue.

In the 1980’s the big issue was depreciation on real estate being given to taxable partners by tax exempt partners in exchange for other benefits.   If this were allowed to proliferate there would be no corporate income tax as private equity partnerships manage companies from a tax exempt status and drive tax paying competitors out of the market with lower prices.

One can forget that taxes are indeed one of the most significant business expenses and eliminating this expense would provide a significant competitive advantage for these private equity firms.

Private equity funds have grown dramatically since then, most notably Blackstone, KKR and TPG.  These firms now receive most of their funding from tax exempt public pensions, foundations and endowments, at times more than 80 percent for particular partnerships.  At the same time they are aggressively investing in businesses which derive most of their revenue from government programs.  A good example is Blackstone’s recent purchase of Oregon’s largest assisted living center, Sunwest, an entity whose primary source of sales are government medicare and medicaid payments.

Somehow the public has been fooled into thinking private equity is something other than a euphemism for leveraged buyout.  And while tax exempt investors, mostly public pensions, use sophisticated LBO strategies including  these Caymen Island based “blocker corporations” to avoid paying UBIT (unrelated business taxable income), they appear to have altogether neglected the significance of the “fractions rule” and basic economic substance requirements regarding allocations of financial results.

Congress set up the UBIT rules specifically to avoid a situation in which tax exempt entities are partners in private equity partnerships and investing in leveraged buyouts, to maintain a level playing field.  The idea was to tax these tax exempt entities on profits gained from such leveraged buyouts, that is UBIT tax.

As noted, the UBIT rules regarding leveraged buyouts have  however been circumvented through the use of off shore “blocker corporations” set up as an intermediary so that the tax exempt entities are seen as investing in a corporation rather than a partnership in which activity flows directly to them as a partner, for example profits and tax deductions.

Nevertheless, the fractions rule math is pretty simple as follows: if for example 70 percent of Blackstone’s investment partners are tax exempt, then 70 percent of certain tax deductions are unusable and can not be transfer priced or allocated into a situation, whether by using equity compensation, carry fees or other expenses in which they are transferred to and used by taxable partners.

While the nation debates whether to tax private equity and hedge fund partners at ordinary or capital gains rates, more interesting is whether or not these partners like Schwarzman are in clear violation of existing IRS tax rules due to an aggressive tax strategy using stock options and carry fees, and other deductions.  Once these machinations are fully understood, the tax benefits could be disallowed if the fractions rule has been violated.

As an example, let’s briefly examine the Blackstone Group more closely, whose President Tony James visited Portland, Oregon in July 2010.  Blackstone is arguably the global leader in private equity investment.  They are also a major risk for investment advisers like myself given their ability to takeover good companies and remove them from the marketplace.  This makes my job much more difficult, not only in selecting good investments, yet also in maintaining clients who suffer an unnecessary job loss due to one of these senseless takeovers that are now proliferating.

Blackstone and other private equity firms including KKR and TPG essentially set up partnerships with tax exempt entities like Oregon PERS, LLC’s,  and often have as little as 10 percent of their own equity in the deals.  “Tax efficiency reasons” are often cited for private equity funds’ low equity participation.  The partnerships then do buyouts of both public and private companies.  The above agenda summary is from a recent presentation by Blackstone in Oregon.

As Tony James noted in his presentation which led to a $200 million investment in a Blackstone partnership, they can now use Blackstone stock as currency to attract top executives by swapping out their unvested stock options for Blackstone options.

That may be convenient yet IRS rules are very clear in prohibiting the trading of valuable tax deductions between taxable entities and tax exempt entities such as public pensions due to abuses in the 1980’s.

Specifically, the “fractions rule”., IRC, 514(c)(9)(E)  was adopted and it only allows the taxable entities to take their share of economic interest in the partnerships.  For example, the taxable partners could only take 100 percent of the equity compensation tax deductions when there are no tax exempt partners.

What it also does not allow is an aggressive strategy using transfer pricing and allocations to circumvent the rule.  Such strategies may reduce tax exempt entities exposure to UBIT yet the fractions rule must still be met.

What the IRS clearly did not want was tax exempt entities like CalPERS and Oregon PERS taking a greater share in profits in lieu of trading unusable tax deductions, deductions they were not entitled to  as a tax exempt entity.  A related specific purpose of the rule was to provide a disincentive to do leveraged buyouts, thereby capturing large interest expense deductions and allowing taxable partners to avoid all tax on their profits.   And while Congress debates whether or not to levy ordinary income or capital gain tax rates on private equity managers, it is conceivable that a tax rate of 75 percent could still result in no tax being paid by general taxable partners such as Blackstone’s Schwarzman.

Many creative and aggressive tax strategies have been adopted by large law and accounting firms to try to get around this fractions rule.   These firms, once referred to as the Big 8, yet now the “Final 4,” all have large divisions focused on hedge funds, private equity and transfer pricing related strategies, to minimize taxation.  In addition to being Blackstone’s auditor, Deloitte is also the auditor of record for Oregon’s private equity portfolio.

The question becomes, are the taxable partners at Blackstone using capitalized carry fees and aggressive transfer pricing rules to avoid all taxation?  My practice includes roughly 20 PERS participants here in Oregon and I made a public records request for Blackstone, KKR and TPG’s K-1 partnership filings, yet was told that Oregon does not receive them for most partnerships and for those it does, maintains no file of them.

Remarkably, the Oregon Attorney General’s office adopted the philosphy that since Oregon PERS is tax exempt they need not ask for nor review this critical document reported to the IRS, but rather rely exclusively on documents prepared by Blackstone, KKR and TPG for information.  For this reason the OIC does not even maintain files for K-1’s in general.  This is somewhat ironic since the current Chair of the Council is Harry Demorest, former managing partner of Arthur Andersen’s Portland Office.  Demorest  managed the tax practice at Arthur Andersen before assuming control over the entire office and clearly if anyone should understand the importance of receiving a K-1, it is Demorest.  Another council member, Richard Solomon, is also a practicing CPA.

The following are samples of the few K-1’s they maintain at Oregon PERS.  They are for KKR and TPG  and were obtained via public information request.  When asked for a simple description regarding the accounting treatment for carry fees, which do not appear directly on these K-1’s as capital transfers,  the Treasurer’s office refused to provide this information.

One obvious question is why the K-1 capital accounts are so low in relation to the publicly available investment summary by partnership.  Many things could explain this yet where is the basic transparency.  And why won’t the Oregon Investment Council even disclose the accounting treatment they are using for the significant carry fees being paid to general partners?  Also of interest is perhaps that KKR’s K-1 is done on a “tax books” basis while TPG uses GAAP accounting.

One could argue that tax exempt investors have nothing to gain from receiving a K-1, yet that is simply ridiculous.  The K-1 is a key document that includes information regarding values, distributions, etc.  My guess is that this is prevalent among public pensions and would it not be interesting to compare the K-1’s provided to taxable partners to those provided to tax exempt partners?

These private equity firms are famous for providing a wide range of “figures” on key reports and related valuations.   The Financial Times, (see summary visual) has reported that Blackstone valued one  investment at 125 percent higher than TPG when even though this investment is in the latter company for an equal amount.   These valuations are critical because they drive transfer pricing, related deductions and allocations, etc.

Goldman Sachs even has its own internal specialized exchange which values private equity interests and is where many such private equity interests are bought and sold.  It is called the GSTrUE system and is only accessible on approved Bloomberg terminals.  Remarkably, not even the Institutional Trading areas at TD Ameritrade or Charles Schwab have access.  Perhaps this “dark exchange” needs a little daylight cast, especially since the biggest investors in such partnerships are taxpayers via the various public pension systems.

Let’s face it, taxes can be boring yet this discussion is important to all investors given that the current level of “buyouts” is removing many quality investments from the market that are later loaded up with debt so that the private equity firms can more quickly earn their “carry fees,” which are generally 20 percent of all profits after returning the original investment to partners.   What also results is a job destruction machine that undermines the economy and stability of the financial markets, not to mention the tax base.  Most importantly, this undermines investor confidence with the perception that investing has become an insiders’ game of manipulation.

Here is a summary of a few potential “discussion issues” to consider affecting just one private equity firm, Blackstone.

1)  The CEO of Blackstone Tony James noted in a public meeting in Oregon that Blackstone options are being used in exchange for unvested options for various purposes, including attracting key management talent.   He also noted that Blackstone uses numerous internal “non-profit” cost centers to serve its various portfolio companies in the subsidiary partnerships, many of which have tax exempt investors.   The question becomes how this impacts transfer pricing and the allocation of valuable tax deductions.

One related question is the following: by manipulating the cost of products and services provided to portfolio companies, are they essentially creating compensation related carry/stock option tax deductions at the Blackstone level to be allocated to taxable partners, when they belong to tax exempt investors and should be unusable?

2)  Blackstone’s 10K for the period ending 12/31/2009 does not disclose what would be material adjustments for disallowed equity compensation deductions belonging to tax exempt investors.  These pertain to equity compensation in which the executives provide services to portfolio companies.  At the July 2010 Oregon PERS  public meeting, James used the example of hiring Gerry Murphy of Kingfisher, one of the UK’s largest firms, by swapping his unvested options for Blackstone options.  James also highlighted the service Murphy provides to specific portfolio companies in the partnerships.

If Blackstone is creatively allocating expenses to its various partnerships, why hasn’t it disclosed the portion of this equity compensation and other related deductions which should be disallowed because they belong to tax exempt partners via an allocation of related expense.

Blocker corporations may solve their UBIT tax issues, yet the fractions rule must also be independently satisfied.

Many other related questions arise when exchanging options for firms acquired.  These deductions need to stay at the acquired firms, yet their value would have been created by the transfer of the Blackstone options, even if the Blackstone Group LP company is not taking a deduction.

Where is the disclosure in Blackstone’s 10K regarding the disallowed carry executive compensation expense?  The firm recognized almost $24 billion of such carry related compensation expense reducing its income by more than $3 billion in 2009.

3)  The Blackstone 12/31/2009 10K displays the line item stating “non-cash equity compensation” of $3 billion.  This resulted in a net loss as shown of approximately $2.4 billion in 2009.

If this entire amount of equity based compensation listed above pertains to a tax deduction, as it usually does with respect to such a line item on a “cash flow statement,” this would imply that Blackstone pays no federal income tax for activity in 2009.

Granted they may indeed pay tax related to other areas, for example, property tax, timing differences from prior year.  The key question becomes, how much of this equity compensation amount pertains to services provided to portfolio companies and what part should be disallowed given that the portfolio company is now partly owned by a tax exempt entity?   Also, is this a material omission by Blackstone’s auditor, Deloitte?

4)  The Chair of the Section on Taxation for the American Bar Association wrote the following letter directly to the IRS commissioner Doug Shulman on January 19, 2010 concerning partnership allocations permitted under section 514(c)(9)(E).    What he is specifically asking for is a revenue ruling to permit more aggressive strategies with respect to the allocation rules regarding partnerships with tax exempt entities, i.e, violating the spirit of the fractions rule.  The entire letter with extensive comments can be accessed on-line with a Google search.

Following the letter in this blog post is a list of clients for the lawyer whose firm King &  Spalding was a key contributor in authoring the letter.

The key attorneys noted as contacts involved with drafting this letter to IRS Commissioner Doug Shulman on behalf of the American Bar Association are the following.

In a testament to their legal prowess, the first attorney noted works for King & Spalding, a firm that lists three of the four largest CPA firms, Price Waterhouse Coopers, Ernst & Young and KPMG as  clients, along with Goldman Sachs, Citigroup, Bank of America and Wells Fargo.

At the same time the ABA is seeking a revenue ruling waiver from the IRS, the private equity and hedge fund industries are pursuing a simultaneous track in Congress.  This was introduced in the 110th Congress and reintroduced as H.R.3497 in the 111th Congress.  Both bills are sponsored by Sanford Levin of Michigan (not to be confused with younger brother Carl Levin in the U.S. Senate).   H.R. 3497 has only three co-sponsors and has been referred to the appropriations committee where Sanford Levin is chairman.

Perhaps most interesting is that at the same time U.S. Representative Sanford Levin is introducing a bill that could dilute the fractions rule, he is also introducing another bill, H.R. 1935, to tax private equity partners at ordinary income rates.  The irony is that his one bill, H.R. 3497, could indeed result in no tax, regardless of the rate.

Meanwhile his younger brother Carl Levin is co-sponsoring a bill with Jeff Merkley of Oregon designed to help states avoid teacher layoffs.  Carl Levin has also been a leader in the effort to reform stock option accounting.  It is unfortunate that a key driver in the funding gap in state governments is increased Public Employee Retirement System contributions due to significant investment losses and concern over the lack of liquidity with respect to their private equity portfolios.

I have some simple advice for the current administration.  Aggressively enforce the fractions rule and prohibit tax exempt organizations from using blocker corporations or any other vehicle that ultimately results in a leveraged buyout within three years of a firms’ acquisition by a partnership in which they participate.  If we simply eliminate the fuel for these senseless takeovers, that is tax exempt pension and endowment money, we’ll go a long way toward protecting good companies along with their employees and current investors.

For those of you wanting to enjoy a little Sunshine and rub shoulders with Wayne Pressgrove and other key voices from the American Bar Association in this debate, including leaders at the Internal Revenue Service, consider attending the upcoming conference in January at the Boca Raton resort.  Details are provided below.  Perhaps it is somewhat ironic that indeed the Blackstone Group now owns the Boca Raton resort via one of its real estate partnerships.

Perhaps also ironic is that Blackstone’s novel approach of issuing a publicly traded security on the New York Stock Exchange, one that is not a stock but rather a partnership allowing tax benefits to flow directly to general partners, may afterall allow many of those same benefits, if indeed such deductions lack economic substance, to flow right back to the Treasury.   For taxpayers, both individuals looking at higher rates and corporate alike, including the likes of Warren Buffett who has roundly criticizes this structure,  this could amount to “sweet justice.”

Perhaps my alma matter, the University of Oregon, may indeed set a good precedent by defeating the Auburn Tigers, Pressgrove’s alma matter, the week prior in the BCS championship series.  Spending several hours putting this post together should allow me at least a little comic relief 🙂

Read Full Post »