March 29 (Bloomberg) -- Blackstone Group LP, the private- equity firm seeking to raise $4 billion in an initial public offering, plans to use a tactic to reduce taxes that may be challenged by the Internal Revenue Service.

In a March 22 filing with the U.S. Securities and Exchange Commission, New York-based Blackstone said it will organize as a limited partnership, avoiding the 35 percent corporate tax on most of its income and giving it a competitive advantage over rivals such as Goldman Sachs Group Inc. and Morgan Stanley.

``We believe we will be treated as a partnership and not as a corporation for U.S. federal income tax purposes,'' Blackstone said in announcing the largest initial public offering by a U.S. buyout firm. ``The IRS may challenge this conclusion and a court may sustain such a challenge.''

The strategy mimics one adopted by Fortress Investment Group LLC, a private-equity and hedge-fund manager that went public Feb. 8 and offered investors a similar warning. It hinges on the use of a 1987 exception in the tax code that offers favorable treatment to publicly traded partnerships that earn more than 90 percent of their income from passive investments, including interest, dividends, and capital gains.

REIT Parallel

Actively operated businesses -- those that produce goods and services -- are taxed as corporations before distributions are made to shareholders as dividends. Partnership income flows directly to shareholders without intermediary taxation. The transaction Blackstone plans has parallels with the tax treatment of real estate investment trusts, most of which have publicly traded shares but are predominately passive investment vehicles.

The trick for Blackstone is to qualify as a partnership with passive investments in the eyes of the IRS while at the same time avoiding regulation as an investment company under a 1940 law, said Victor Fleischer, a law professor at the University of Colorado in Boulder.

``I do believe they are speaking out of both sides of their mouth a little bit,'' said Fleischer, who has drafted a paper on the taxation of partnership profits in private-equity funds -- the so-called carried interest part of a fund manager's compensation. Fleischer reported on Blackstone's proposal on his blog.

Congressional Action

The strategy appears to be legal, he said. Still, ``I don't think Congress had this in mind when it wrote the publicly traded partnership rules in 1987,'' he said. ``If they change the rules, the investors in Blackstone are going to see a decline in the value of their investment.''

Blackstone spokesman John Ford said the firm wouldn't comment beyond what it disclosed in documents. IRS spokesman Robert Marvin declined to comment.

Donald Williamson, chairman of the accounting department in the Kogod School of Business at American University in Washington, said Blackstone appears to be trying to get around 20-year-old rules designed to ensure that large entities with thousands of shareholders pay corporate tax.

``This sort of parsing is exactly what drives Capitol Hill crazy,'' he said. The laws as drafted ``were originally designed exactly to snuff out the kind of thing Blackstone is trying to do.''

Publicly traded partnerships, or master limited partnerships, are often referred to as ``Energy REITS'' because about 80 percent of them are oil and gas pipelines or otherwise involve natural resources, according to Mary Lyman, spokeswoman for the National Association of Publicly Traded Partnerships, a Washington trade group. Tax law ordinarily treats investment firms as companies rather than partnerships.

Tightening Rules

Congress responded to a proliferation of such arrangements in the early 1980s by tightening the rules in 1987. Today, the non-energy companies still using the structure under grandfather rules include Sandusky, Ohio-based amusement park owner Cedar Fair LP and ML Macadamia Orchard LP of Hilo, Hawaii, the distributor of Mauna Loa macadamia nuts.

Documents filed with the SEC show Blackstone earned $2.27 billion in 2006, 71 percent more than a year earlier. Money- management fees were $1.12 billion, and investment gains totaled $7.59 billion.

According to its plan, Blackstone would sell IPO investors a piece of its management company, not the private-equity funds themselves, and won't share in the profits from the firm's investments, which are taxable to the firm's principals at the 15 percent capital-gains rate. Blackstone said it will receive a legal opinion from the law firm Simpson Thacher & Bartlett LLP that endorses the tax structure. It advised in the filing that such an opinion isn't binding upon the IRS or courts.

Tax Structure

Under the proposed tax structure, only management fees would be taxable at corporate rates, with the payments up to the publicly traded holding partnership being treated as dividends, according to Fleischer. Profits from investments would continue to flow untaxed to principals and investors who would pay tax at the individual level.

Robert Willens, an accounting analyst at Lehman Brothers Holdings Inc., said Blackstone may be able to accomplish its goal because the tax code clearly identifies the types of income it can earn under the structure it proposes.

``If Blackstone earns the type of income specified in the requisite quantities, then that should be the end of the inquiry,'' he said. ``It's not proper, in these cases, as a matter of statutory construction, to inquire into whether the `spirit' of the statute has been well served.''

Blackstone and other private equity firms moved in recent months to shore up their lobbying presence in Washington, helping to fund the Private Equity Council. The organization will ``conduct research and provide information about the industry to policy makers and others interested in understanding what private equity is, how it operates and the increasingly important role this alternative asset class plays in the U.S. and global economy,'' according to a Dec. 26 press release.

To contact the reporter on this story: Ryan J. Donmoyer in Washington at rdonmoyer@bloomberg.net

Last Updated: March 29, 2007 18:08 EDT