Is a billion dollars ordinary income?

By Jonathan Peterson and Walter Hamilton

July 21, 2007 12 AM PT

Times Staff Writers

WASHINGTON —

In a new age of fabulous fortunes, the tax rate paid by a breed of financial billionaires is fueling a Wall Street-versus-Washington dispute over fairness in the U.S. economy.

Leaders of private equity firms such as Blackstone Group and Kohlberg Kravis Roberts & Co. are reaping huge paydays as they buy and sell some of America’s biggest companies. But much of the money they pocket is considered investment income, and taxed at the 15% rate for capital gains.

Congress is now considering taxing these earnings at the ordinary income tax rate -- which for Wall Street titans (and anyone else who makes $349,700 and up) is 35%. The proposal has triggered a debate that is echoing across the political landscape and on the presidential campaign trail.

“Tax fairness -- the ability to tell our constituents that taxpayers are being treated fairly and equitably -- that’s really the basic issue here,” Rep. Sander M. Levin (D-Mich.) said.

More broadly, the issue is hitting a public nerve at a time when many middle-class families struggling to stay afloat could be paying higher tax rates than financial magnates.

Levin’s proposal could mean a bigger tax hit for highly paid managers at thousands of investment partnerships including private equity funds, venture capital funds, real estate trusts and certain types of hedge funds.

A more narrow Senate proposal would apply only to private-equity firms and other funds that are publicly traded, such as Blackstone Group.

Opponents of the legislation say the current system fosters innovation and economic growth by rewarding those who are willing to risk their money on new business ventures. Buyout firms, fund managers and the U.S. Chamber of Commerce are among those scrambling to block the tax change.

Investor Henry Kravis -- legendary for his 1989 takeover of RJR Nabisco detailed in the bestseller “Barbarians at the Gate” -- trekked to Congress recently to make his case in private meetings with lawmakers.

“A knee jerk by Congress to come in here to raise tax rates to raise revenues could have serious consequences to U.S. capital markets, to capital formation,” warned R. Bruce Josten, executive vice president of the U.S. chamber.

Private equity’s rise

The controversy is rooted in the rise of private equity executives from bit players to their current status as the rock stars of Wall Street. Such firms specialize in taking over troubled companies, whipping them into shape and selling them for a big profit. The biggest firms are now serious rivals to New York’s blueblood investment banks.

Last month’s initial public stock offering of Blackstone Group revealed just how fantastically wealthy private equity managers have become, even by Wall Street’s surreal pay standards.

Stephen Schwarzman, Blackstone’s chief executive, pocketed almost $400 million last year -- easily topping the $55 million earned by Lloyd Blankfein, his counterpart at Goldman Sachs Group.

After the public offering, Schwarzman’s ownership stake in Blackstone was valued at about $7.5 billion, up from $3.5 billion last year.

Blackstone said in a government filing for its IPO that the measures could significantly boost the taxes owed by its executives, but said that it did not know by how much.

These days, private equity titans such as Schwarzman and Kravis are as visible in New York society as they are in corporate boardrooms, a status that recalls an earlier generation of Wall Street barons.

Schwarzman’s glitzy 60th birthday bash this year featured private performances by Rod Stewart and Patti LaBelle. For his annual Christmas parties, Schwarzman, who is chairman of the Kennedy Center in Washington, has been known to decorate his Park Avenue apartment to look like a Las Vegas casino and a St. Tropez beach.

Kravis, the chief of Kohlberg Kravis Roberts & Co., has an estimated net worth of $2.6 billion. He serves on the boards of New York’s Metropolitan Museum of Art and Mount Sinai Medical Center. Kravis’ wife, Marie-Josee, is president of the Museum of Modern Art in New York.

As some see it, the political focus on taxes paid by the investor elite is an inevitable consequence of their huge, widely noted windfalls.

The fact that fund managers can earn millions of dollars that is taxed at 15% is “a blatant example of profiteering legally from the tax system,” said Max B. Sawicky, an economist at the Economic Policy Institute.

“It offends our values as a nation when an investment manager making $50 million can pay a lower tax rate ... than a teacher making $50,000,” Sen. Hillary Rodham Clinton (D-N.Y.), a presidential candidate, declared in a campaign statement.

Upside to risk-taking

For all that, critics of the tax proposals say the focus on ultra-rich private equity firms could lead to a big policy blunder.

Kate D. Mitchell, a venture capitalist from Northern California, said the proposed tax hike would hurt innovation and punish those who take risks to launch the would-be Googles of the world.

In testimony to the Senate Finance Committee last week, she argued that current rules offer an important upside to risk-taking. Further, she wanted to make clear that the tax provision under fire actually benefits many entrepreneurs who do not fit the stereotype of the super-elite.

“I wanted to get our message across,” recalled Mitchell, who is managing director of Scale Venture Partners, a $400-million fund based in Foster City, Calif. And she wanted a reporter to know: “I drive a ’95 Volvo.”

Hedge funds, which engage in a variety of investment tactics, also may qualify for the capital gains rate for profits on investments that they have held for at least a year. In these cases, managers also could face higher taxes under the Levin proposal. Some hedge funds would not be affected, however, because they focus exclusively on short-term investments.

Political involvement

As the stakes have grown, so has the political involvement of Wall Street’s elite. Contributions to presidential hopefuls from the industries of private equity and hedge funds have surpassed $4.1 million this year, according to an analysis by the Center for Responsive Politics, a nonpartisan watchdog group.

Topping the list was former Massachusetts Gov. Mitt Romney, a Republican with $797,325 in receipts, closely trailed by Sen. Christopher J. Dodd (D-Conn.) with $726,950, and Clinton with $703,600.

The industry also has made more than $1 million in donations to Democratic and Republican campaign funds and House and Senate candidates this year.

Schwarzman and Kravis are both substantial and longtime donors to the Republican Party, according to data compiled by the Center for Responsive Politics.

Schwarzman and his wife have given $134,850 to federal candidates, political action committees and party committees since 2005, all but $10,300 of it to Republicans. Kravis and his wife have given $110,600, all but $10,000 of it to Republicans. Both have contributed to presidential candidate Sen. John McCain (R-Ariz.) this year.

But the tax debate does not completely break down along tidy partisan lines. Sen. Charles E. Grassley (R-Iowa) has expressed distaste for what he calls a “loophole” exploited by wealthy investment firms. And in the Northeastern states of New York and Connecticut, where many of the richest investors work and live, some Democratic lawmakers have taken a cautious approach to the flap.

After the Senate bill was introduced, Dodd and a Republican colleague fired off a letter to Treasury Secretary Henry M. Paulson Jr., declaring that the measure raised “many questions” about its effect on U.S. capital markets, and seeking the secretary’s view on the matter.

Separately, Sen. Charles E. Schumer (D-N.Y) made clear that he was uncomfortable with the fact that the Senate bill singled out investment firms.

“I will not stand for treating financial-services partnerships one way, while all the other partnerships are treated another way,” he said.

jonathan.peterson@latimes.com

walter.hamilton@latimes.com

(BEGIN TEXT OF INFOBOX)

Backstory

What

House and Senate legislation that would alter the tax code to restrict the ability of partners in investment partnerships to have their income taxed as

capital gains, at a preferential rate. The House bill would apply to private equity firms, certain hedge funds, venture capital funds and real estate trusts. The Senate bill is limited to the small group of private equity firms that go public.

Background

The bills were prompted by concerns that managers in rich investment partnerships were benefiting unfairly, at a time of growing income inequality in the United States.

Status

No votes have been taken; hearings are expected before August recess.

Source: Times research

(BEGIN TEXT OF INFOBOX)

Tax rates

Income tax brackets for married couples filing jointly.

* 10% on as much as $15,650

* 15% between $15,651 and $63,700

* 25% between $63,701 and $128,500

* 28% between $128,501 and $195,850

* 33% between $195,851 and $349,700

* 35% above 349,700