Tell us why Romney will be a great president.

[erfalf]

You may well be right about that one. 

Big gripe with that is the preferential tax treatment awarded to the people running the operation.  Capital gains treatment on regular income?  Come on...

Look, I'm not going to go back and forth with you over what is capital gains and what isn't, mostly because I would agree with you on many aspects. In particular, carried interest. PE firm owners have figured out how to get their "normal income" (what they do for a living) into capital gains.

In my opinion, this is how it should work:

Generally the GP (General Partner/PE Firm) has an interest in the Limited Partnership of a few percent. Let's say it cost them $1 Mil and they made $5 Mil. They should get $4 Mil at capital gains rates (whatever that is at the time since it will show up on the K1). The carried interest portion should be taxed at ordinary marginal tax rates. I think it is only fair since the carried intereast portion is really the only part that is part of the tax payers normal line of work. They should be treated like dividends more or less.

Some people (I know, I shouldn't use that word) have said what about day traders and what not, that invest in equities. But there is already a sort of safeguard for that. They only get the capital gains rate if they hold the assets for a specific amount of time (one year only, but still it's something).

[erfalf]

We've been over this before. The interest, which is the cost of capital when equity is replaced by debt in an LBO, is tax deductible. That's preferential treatment. I'm not sure how we'd eliminate that even if we wanted to, because it's certainly reasonable for interest expense on a loan to buy production equipment to be deductible as a business expense. However, just because we can't make a distinction in the tax code does not mean we have to shut down our brains and ignore it.

Let's say you finance something for a business. You pay $100. You paid $5 in interest over the year, but you were able to deduct it to reduce you taxable income. It still cost $100. And the deduction didn't actually save you $5, it only saved you $1.75 in taxes. So that product actually still cost you $103.25 over the first year. Hardly a huge tax advantage if you ask me.

I've read some comentary on this and they all seem to be missing the same point. There is a cost of borrowing money. It is considered a cost of doing business. Heck it's considered a cost of living as well considering home mortgage interest is also tax deductible. There is no real benefit from my point of view tax wise. Now there is a huge benefit to borrowing in that businesses can expand when they otherwise couldn't with the resources they had at the time.

[nathanm]

Let's say you finance something for a business. You pay $100. You paid $5 in interest over the year, but you were able to deduct it to reduce you taxable income. It still cost $100. And the deduction didn't actually save you $5, it only saved you $1.75 in taxes. So that product actually still cost you $103.25 over the first year. Hardly a huge tax advantage if you ask me.

Interestingly, tax experts disagree with your statement that it's not a huge advantage. That's not the only advantage, of course, but you know that.

[Red Arrow]

Interestingly, tax experts disagree with your statement that it's not a huge advantage. That's not the only advantage, of course, but you know that.

Are you saying the cost of doing business should not be deductible?   I always thought profit (income) was gross receipts minus cost.

[nathanm]

Are you saying the cost of doing business should not be deductible?   I always thought profit (income) was gross receipts minus cost.

No. Read my earlier posts in this thread.

I have a problem with the tax deductibility of debt when when it is used to almost completely replace equity in the structure of the organization. It encourages weakness in our institutions. But, as I said before, I don't know how the heck you'd make a reasonable distinction between debt used in the way LBO shops use it and debt used in the way normal companies use it. (and there is a significant difference in the way companies owned by LBO shops use debt and the rest of the corporate world uses debt)

We're essentially putting these companies at an artificial advantage relative to their competitors whose capital is supplied by equity, and in doing so encouraging them to take on more risk. That advantage, combined with being the sole equity holders, is what enables LBO shops to make such great (cash) profits.

[erfalf]

No. Read my earlier posts in this thread.

I have a problem with the tax deductibility of debt when when it is used to almost completely replace equity in the structure of the organization. It encourages weakness in our institutions. But, as I said before, I don't know how the heck you'd make a reasonable distinction between debt used in the way LBO shops use it and debt used in the way normal companies use it. (and there is a significant difference in the way companies owned by LBO shops use debt and the rest of the corporate world uses debt)

We're essentially putting these companies at an artificial advantage relative to their competitors whose capital is supplied by equity, and in doing so encouraging them to take on more risk. That advantage, combined with being the sole equity holders, is what enables LBO shops to make such great (cash) profits.

What the difference? If a PE firm acquires the firm, they are that firm. They use debt just like every other business entity: to make more money. You know what happens after that? They pay more taxes.

I'd like to put the insane leveraging of PE firms in perspective. The following are the debt to equity ratios of some major companies. Notice it is the debt to equity ratio and not the other way around. It's like that for a reason

5.31 - Facebook (N/A)
12.55 - Google (N/A)
19.25 - Microsoft (0.80)
30.07 - Staples (0.44) Bain Portfolio Company
35.55 - General Motors (N/A)
42.08 - Philllips 66 (0.80)
58.05 - ConocoPhillips (2.64)
97.39 - Steel Dynamics (0.40) Bain Portfolio Company
160.60 - Williams Companies (1.25)
584.91 - Ford Motor Company (0.20)
American Airlines - apparently we don't need to know this one, but their current ratio is 0.59, ouch.

Please don't continue the line that PE firms borrowing is excessive compared to their competitors. As you can see what PE borrows is relatively tame in comparison to what their takeover targets are doing. Maybe that's the reason some of them are struggling. And generally LBO firms are not the sole equity holder. They often have a group of PE investors that invest simultaneously.

And if it makes a different, the government shafted TPG Capital out of a $1.35 Billion (with a B) investment in Washington Mutual.

[heironymouspasparagus]

Look, I'm not going to go back and forth with you over what is capital gains and what isn't, mostly because I would agree with you on many aspects. In particular, carried interest. PE firm owners have figured out how to get their "normal income" (what they do for a living) into capital gains.

In my opinion, this is how it should work:

Generally the GP (General Partner/PE Firm) has an interest in the Limited Partnership of a few percent. Let's say it cost them $1 Mil and they made $5 Mil. They should get $4 Mil at capital gains rates (whatever that is at the time since it will show up on the K1). The carried interest portion should be taxed at ordinary marginal tax rates. I think it is only fair since the carried intereast portion is really the only part that is part of the tax payers normal line of work. They should be treated like dividends more or less.

Some people (I know, I shouldn't use that word) have said what about day traders and what not, that invest in equities. But there is already a sort of safeguard for that. They only get the capital gains rate if they hold the assets for a specific amount of time (one year only, but still it's something).

The hedge fund guys were able to buy Congress so that they DON'T have to wait the year for long term gains - it is immediate.

[heironymouspasparagus]

Let's say you finance something for a business. You pay $100. You paid $5 in interest over the year, but you were able to deduct it to reduce you taxable income. It still cost $100. And the deduction didn't actually save you $5, it only saved you $1.75 in taxes. So that product actually still cost you $103.25 over the first year. Hardly a huge tax advantage if you ask me.

I've read some comentary on this and they all seem to be missing the same point. There is a cost of borrowing money. It is considered a cost of doing business. Heck it's considered a cost of living as well considering home mortgage interest is also tax deductible. There is no real benefit from my point of view tax wise. Now there is a huge benefit to borrowing in that businesses can expand when they otherwise couldn't with the resources they had at the time.

You forgot about depreciation if it was a capital expenditure, and expense deduction if not.  And some capital spending benefits from accelerated depreciation, so get to deduct a portion of that spending every year until done.  Can be from 1 year to 5 or 7 or 10 (or more) depending on what it is, it's life expectancy, etc.  There is a list...  

And if it is a building, you get to deduct the cost over a period of time (IIRC, 20 to 30 years...) then at the end, in addition to having the benefit of deducting the cost, if you decide that place is too small or too big, sell it and buy another - any amount made is not regular income, it is a long term capital gains, benefiting from 15% max rate, just like a stock purchase.  Sweet deal.  You get a tax deduction on the front end and a big tax break on the back end.

Unless of course, you can get $1 a year rent like out at the airport...then you never have to spend a penny.  Just a buck.


Just curious - what did you study in college?  Rhetorical question - you don't need to answer if you don't want to...but I can tell it wasn't engineering, and gawd I hope it was not business...!

[nathanm]

What the difference? If a PE firm acquires the firm, they are that firm. They use debt just like every other business entity: to make more money. You know what happens after that? They pay more taxes.

I'd like to put the insane leveraging of PE firms in perspective. The following are the debt to equity ratios of some major companies. Notice it is the debt to equity ratio and not the other way around. It's like that for a reason

5.31 - Facebook (N/A)
12.55 - Google (N/A)

After noting that the first two on your list have equity in excess of liabilities according to their most recently released balance sheets, I disregarded the rest.

[Red Arrow]

And if it is a building, you get to deduct the cost over a period of time (IIRC, 20 to 30 years...) then at the end, in addition to having the benefit of deducting the cost, if you decide that place is too small or too big, sell it and buy another - any amount made is not regular income, it is a long term capital gains, benefiting from 15% max rate, just like a stock purchase.  Sweet deal.  You get a tax deduction on the front end and a big tax break on the back end.

I believe taxes are paid on the amount of the selling price above the depreciated price so you are paying back some of that 20 to 30 year tax advantage.  If you can only sell for the depreciated value, then that was truly a cost of doing business.

[heironymouspasparagus]

That was the quick version...there are more details.  If you pay off the building over the 20 or 30, then the whole thing is fully depreciated - one of the details that changes as you mentioned on the balance due and depreciated amounts.  You can do well buying new equipment on a regular interval.

And if the value goes down, there is an opportunity for a loss - depending....

Good friend drove nice cars for better than free - actually "made" money trading them in regularly and using a heavily front end loaded depreciation schedule...not really making money, but driving almost new car pretty much all the time, with very low relative cost.  At least that is what he thought...and the books seem to back it up.

I just drive 'em until the wheels fall off, then get another one.  Gives me the lowest cost that I have experienced.

[erfalf]

The hedge fund guys were able to buy Congress so that they DON'T have to wait the year for long term gains - it is immediate.

How's that?

[erfalf]

You forgot about depreciation if it was a capital expenditure, and expense deduction if not.  And some capital spending benefits from accelerated depreciation, so get to deduct a portion of that spending every year until done.  Can be from 1 year to 5 or 7 or 10 (or more) depending on what it is, it's life expectancy, etc.  There is a list...  

And if it is a building, you get to deduct the cost over a period of time (IIRC, 20 to 30 years...) then at the end, in addition to having the benefit of deducting the cost, if you decide that place is too small or too big, sell it and buy another - any amount made is not regular income, it is a long term capital gains, benefiting from 15% max rate, just like a stock purchase.  Sweet deal.  You get a tax deduction on the front end and a big tax break on the back end.

Unless of course, you can get $1 a year rent like out at the airport...then you never have to spend a penny.  Just a buck.


Just curious - what did you study in college?  Rhetorical question - you don't need to answer if you don't want to...but I can tell it wasn't engineering, and gawd I hope it was not business...!

While everything you said is well and good, we have been talking about the source of the funds, not the destination.

Ironically, I started out as an engineering student, and then switched to finance/accounting. Why are business degrees so scary? 

[erfalf]

That was the quick version...there are more details.  If you pay off the building over the 20 or 30, then the whole thing is fully depreciated - one of the details that changes as you mentioned on the balance due and depreciated amounts.  You can do well buying new equipment on a regular interval.

And if the value goes down, there is an opportunity for a loss - depending....

Good friend drove nice cars for better than free - actually "made" money trading them in regularly and using a heavily front end loaded depreciation schedule...not really making money, but driving almost new car pretty much all the time, with very low relative cost.  At least that is what he thought...and the books seem to back it up.

I just drive 'em until the wheels fall off, then get another one.  Gives me the lowest cost that I have experienced.

If the guy was trading them in, he could push back any tax liability he may have incurred. But the day he sells one (does not trade it in) he will have to pay the piper. Course he may never sell one so...

[erfalf]

After noting that the first two on your list have equity in excess of liabilities according to their most recently released balance sheets, I disregarded the rest.

In all fairness I was pulling the data from Yahoo finance. It is the D/E ratio for the most recent quarter. In other words it is the ratio of how assets have been financed for only the current quarter.