How Private Equity and Hedge Funds are Taxed

In recent years private equity (along with its better-publicized cousin hedge funds) has emerged as one of the fastest and most efficient ways to move and foster capital. It lets investors influence or control a company, without worrying about such pesky, quotidian concerns as stock price movements and indignant proxy-holding shareholders.

That’s the upside. The downside is that private equity is a game for only the wealthiest of investors. If you’re not accredited, thanks for your interest but you need not apply. Try again once your monthly 401(k) contributions have reached seven digits.

Private equity is usually structured as a limited partnership; a combination of the best features of corporations and individual ownership, and one of the most beneficial inventions in the history of finance. At the most facile level, the standard criticism of corporations and other special-purpose entities is that they’re equated to “people,” a simplification that causes more misunderstanding than it does enlightenment.

Corporations and limited partnerships are “artificial persons” in the sense that they pay taxes, own property, and can file lawsuits (and have lawsuits filed against them), among other rights and responsibilities. The crucial point here is that the special-purpose entities have these rights and responsibilities beyond those of the individuals, the literal people, who own said entities. In other words, such an artificial person can be held liable for obligations far exceeding those of the owners as individuals. This isn’t just helpful for stimulating growth, it’s necessary. If a budding entrepreneur were to risk being on the hook for more than his investment, no one would ever start a business in the first place. Conferring artificial personhood upon companies gives their owners room to grow without fear of early bankruptcy. Governments allow for the creation of such entities worldwide, meaning that the incentive for doing so is well understood.

There’s another incentive too: a more appealing tax structure. Any independent businessperson who’s advanced from paying taxes on salary or wages to paying taxes on capital gains can attest to the truth of the following postulate: Regardless of what country you live in, the tax system is constructed to accommodate business owners at the expense of clock punchers. You can complain about this state of affairs, or use it to your advantage.

Limited partnerships are taxed at modest rates. In fact, they aren’t really taxed at all. Profits earned and losses incurred by the limited partnership flow directly to the partners themselves, whether they’re individuals or not (trusts, etc.) The limited partnership is just a conduit, unlike a corporation or a general partnership that pays taxes itself – in addition to its owners paying taxes.

Let’s walk through that. Corporations pay federal taxes, in most cases state taxes, and in some cases even municipal taxes, before distributing earnings to shareholders. As anyone who owns stock knows, you have to pay taxes on those distributions, too. That’s double taxation, which is two more levels of taxation than most members of a limited partnership would like to pay if they can help it.

But what if the limited partnership loses money? Well, that’s not necessarily a negative. Again, the losses pass through to the partners. The partners, by virtue of being accredited investors (and thus not poor), almost certainly have their fingers in other investment pies. Therefore, they can use their limited partnership losses to offset gains elsewhere. The manipulation requires the services of a professional tax accountant, but for most limited partners it’s well worth the trouble.

Limited partnerships showcase the stark difference between active and passive income, strictly by the legal definitions of those terms. Unless you perform physical labor for a living, your “active” income is probably earned under passive circumstances, behind a desk in an air-conditioned office for instance.

You don’t get rich, at least not rich enough to be a general partner in a private equity fund, without a capacity for maneuvering your way around the gargantuan and ever-shifting tax code. Such funds can pay a de facto dividend, decree it to be a management fee and then classify that as a non-taxable business expense. Even better, legitimate management fees – which you’d think might be counted as salaried work – instead entitle the managers to a cut of the profits. Which means that that income is taxed at capital gains rates, as opposed to the significantly higher ordinary income rates. Despite multiple attempts by federal legislators of both parties to reclassify such carried interest as ordinary income, not much has changed on this front.

Taxation on hedge funds is similar to that on private equity, at least in the United States. A hedge fund is another form of pass-through entity, allowing the fund itself to operate free of taxation. Instead, when funds are distributed to the partners, those gains (and losses) are taxed at the individual level. There, they could be taxed at long-term capital gains rates, or they could be taxed at short-term capital gains rates. Most importantly, they won’t and never will be taxed as ordinary income.

If the rich get richer, limited partnerships are one of the reasons why. Again, the reality is that those taxes are as arcane and as seemingly counterintuitive as they are by design. The system is built to reward the risk-takers, even though it demands that those risk-takers apply manpower and countless hours to the task of preparing and thus minimizing their tax obligations. It’s all legal, and if you think it’s unfair that the Internal Revenue Code benefits the people who can afford to make $250,000 investments, to begin with, keep in mind that tax laws are written by (or under the authority of) legislators and executives.