The New York Attorney General’s Office launched an investigation against some of the largest private equity firms in the United States, in order to determine if they committed illegal tax strategies.

New York Attorney General

According to the report from the New York Times, New York Attorney General, Eric Schneiderman, issued a subpoena to twelve private equity firms, including Apollo Global Management (NYSE:APO), Bain Capital, Clayton, Crestview Partners, Dubilier & Rice, H.I.G. Capital,  Kohlberg Kravis Roberts & Company (NYSE:KKR), Silver Lake Partners, Sun Capital Partners, Vestar Capital Partners, and Providence Equity Partners.

The attorney general directed the equity firms to submit important documents to find out if there are evidences that certain management fees collected from investors were reported as investment funds to pay lower tax rate.

According to the report, some executives from the private equity firms suggests that Schneiderman’s investigation was connected with objective of the Obama administration to humiliate the industry because of Mitt Romney’s involvement with Bain Capital.

The Obama administration criticized Mitt Romney’s record at Bain Capital for dissolving companies and cutting jobs, while he accumulated millions of dollars in profits. Others believed the inquiry was part of the Taxpayer Protection Bureau of the Attorney General’s Office initiative to recover more revenue under the state law of New York.

Schneiderman is a democrat, and he was also appointed by Pres. Barack Obama as co-chairman of the mortgage fraud task force. One of the President’s priorities during his first term is to crack down on large-scale tax evasion during his first term in office.

According to the New York Times report, the subpoenas issued by the attorney general’s office came out prior to the leak of more than 950 pages of Bain Capital’s confidential financial documents published online by Gawker.com. Based on the documents, Bain Capital converted more than $1 billion in investors fees into investments, instead of reporting them as ordinary income. The strategy enabled Bain Capital to pay a lower rate of 15 percent instead of 35 percent, thus saving more than $200 million in federal taxes and $20 million in Medicare taxes.

Some tax experts believed the tax strategy also called “fee waivers” is legal, others described it as aggressive, and some opined that it is potentially illegal. An academic paper written by Gregg D, Polsky, of the University of North Carolina School of Law, noted that private equity firms regularly attempt to convert two percent of their fixed annual fees into deferred capital gains. According to him, the tax strategy is “extremely aggressive and subject to serious challenge by the IRS.”

A report from the Wall Street Journal cited that a person with knowledge about the investigation said the Attorney General’s Office was concerned about the practice of private equity firms in converting their management fees into investment producing capital gains, as a means to avoid paying proper taxes.

According to the Wall Street Journal, based on documents and filings, Apollo Global Management  (NYSE:APO) and Kohlberg Kravis Roberts & Company (NYSE:KKR) used the fee waiver as a tax strategy.

According to Steve Judge, president and chief executive officer of Private Equity Growth Capital Council, the fee waiver is legal. He said, “Management fee waivers are legal, widely recognized, and often part of negotiated agreements between the alternative investment community and investors.”

Jack Levin, a finance lawyer who represented Bain Capital on some other legal issues, also said the IRS was aware that private equity firms are practicing the fee waiver as a tax strategy for 20 years, and he does not consider the practice as risky or aggressive.

On the other hand, Blackstone Group LP (NYSE:BX), Carlyle Group (Nasdaq:CG), and Madison Dearborn Partners Llc are not using the fee waiver as a strategy in filing their taxes, because of its complexity and possible investigation.

A comment from Professor Ed Kleinbard from the USC Gould School of Law, and former chief of staff at the Congress Joint Committee on Taxation, was quoted by the WSJ that some firms “seemed to have interpreted the silence of the IRS as acquiescence, which is not correct, but the IRS failed to enforce the rules in this area.”

Kleinbard said, “Firms ended up taking positions that I think went beyond what the law permitted.But the IRS failed to do its job of litigating those issues. Had they done so, a lot of these structures, including possibly Bain’s, would have been disallowed.”

Citigroup Research notes:

Two interesting article tidbits — First, the article notes mixed Republican reaction relative to the Democratic-led NYAG, setting up for some battle lines on the topic perhaps. Second, and most interesting to us, the article affirms that there is no
difference in tax treatment in NY between capital gain and ordinary income treatment, suggesting no pick up in state tax receipts. Of course, the NYAG investigation could prompt other state attorney offices to follow suit, where tax treatment may be differentiated and thus subject to further review.
But sector may lag on the news — Like much of the SEC’s valuation inquiry. Citi suspects that the larger players may prove more immune to incremental risks.