A tax inquiry by New York’s attorney general that includes Bain Capital and other private equity firms could prompt other states to look at the tax obligations of such investment companies.
Attorney General Eric T. Schneiderman of New York has subpoenaed documents from Boston-based Bain and at least a dozen other firms, according to a person who was briefed on the matter. The requests relate to a common practice in the industry called “management fee waivers,” when firms forgo the usual 2 percent fee they receive from clients and instead put that money toward investments in their fund.
The practice has the effect of shielding partners’ earnings from regular income taxes and converting it to profits that would be subject to the much lower federal capital gains tax rate of 15 percent.
Bain and its founding chief executive, Republican presidential nominee Mitt Romney, have come under scrutiny for shielding vast portions of partners’ wealth from regular income taxes, using a number of different strategies.
Schneiderman is not trying to challenge federal tax law, specialists said, but rather may be looking at whether New York could claim a higher state tax rate on the converted fees. If he is successful, other states could also try to tap additional revenue from those gains.
“States that are equally savvy could take a look at this,” said Paul Beecy, a partner in Boston for the auditing firm Grant Thornton. He said New York appears to be “delinking from the federal rule. We’ve seen states do this before.”
There may be little fallout from the inquiry in Massachusetts because the state applies the same 5.3 percent tax rate to regular income and long-term capital gains. Still, the Massachusetts Department of Revenue plans to follow the New York case, as it routinely does in similar tax-law matters, spokeswoman Ann Dufresne said.
Across the private equity industry, this practice is one that clients generally favor, specialists in private equity said. That’s because it’s another way for partners at the firms to put their own money on the line in the same deals their clients are investing in. By putting the money at risk instead of just taking it as a paycheck, they could either lose it entirely or reap big gains on it.
Bain Capital declined to comment on the tax inquiry, with was first reported by The New York Times over the weekend.
Bradford Malt, a trust attorney at Ropes & Gray in Boston who handles Romney’s investments, confirmed for the Globe that Romney did not use the fee waiver strategy while at Bain.
In a statement, Steve Judge, chief executive of the Private Equity Growth Capital Council, a Washington group that represents the buyout industry, said, “Management fee waivers are legal, widely recognized, and often part of negotiated agreements between the alternative investment community and investors, including pension funds and endowments.”
The group would not confirm that the IRS had taken a look at the tax matter in 2007 but said there has been no IRS action or guidance on the tax treatment. The IRS declined to comment.