Dubious Proposals for Tax "Reform" of Carried Interests

The debate continues to rage over the taxation at 15% capital gains rates of carried interests received by hedge fund, private equity, and venture capital managers.  At least two pieces of legislation are pending which would tax these carried interests as ordinary income at 35% rates - albeit one of them would do so in only the relatively limited context of publicly traded partnerships. A number of academic proposals to deal with the taxation of carried interests have been made as well.

In brief: under current law, the receipt of a carried interest, if structured as a partnership profits interest in future profits, is not a taxable event .  Moreover, unlike corporate executives who receive equity type interests as compensation, taxation on the carried interest is generally deferred until income is actually received  - often as a pass through of long term capital gains.

Arguments (often simplistic) are being made against this treatment. Arguments (often equally simplistic) are being made in favor of this treatment. This note is not meant to weigh in particularly on one side or the other of the debate.

However, what will be addressed is the effectiveness of the legislative and academic proposals at doing what they purport to do, i.e. raise revenues for the taxman. A review of comment made so far indicates that they are all sorely deficient in this regard. So let’s look at how this could come to pass, take a few potshots along the way, and try to have some fun in the process – if tax law can ever be “fun”.

First, the legislation dealing only with publicly traded partnerships is so limited in scope and application as to be unworthy of any great analysis or criticism. It was clearly a knee jerk high profile reaction to the recent Blackstone  deal and would apply only to a handful of publicly traded private equity and hedge funds. Any tax revenues raised will be inconsequential to the point of meaninglessness.

Second, the other pending bill (the “Levin bill”)  would be more broadly applicable. Essentially it would create a new section in the Internal Revenue Code which will characterize income from a profit share interest attributable to investment management services furnished by a partner to a partnership as ordinary income. The bill would generally affect carried interests in which the partner has made no contribution of investment capital. If the partner has contributed capital, however, the allocation of profits to the partnership interest represented by capital must not be unreasonable, otherwise the bill would apply. There are other provisions dealing with losses, distributions of property, and dispositions of partnership interests. The Levin bill has been roundly criticized on a variety of technical grounds.

Third, besides the legislative proposals a couple of academic proposals have tackled the taxation of carried interest. One such proposal (“Fleischer/Schmolka”) would treat a carried interest as a loan of capital to the general partner (GP) from the limited partners. If the GP has a 20 percent profits interest, he would be treated as if he borrowed 20 percent of the partnership capital for the life of the partnership. The GP would either be required to pay interest on the use of capital or be taxed on the forgiveness of such a payment much like imputed interest on loans. In effect, under this proposal, the GP is treated as receiving a payment for services equal to the interest-free use of capital. A second proposal (“Gergen”) would treat any payment on a profits interest as ordinary income (and grant the partnership a deduction for the same amount, which would then potentially be capitalized.) The approach taken in the Levin bill discussed above is similar to the Gergen approach.

The problem with all the proposals is that, like the horcruxes of Lord Valdemort which Harry Potter of the fictional Harry Potter series has to deal with before he can extinguish that evil villain, every imaginable manner of escape for the perceived “evil”  of the current tax treatment of the carried interest has to be closed.  If not - a lot of legislative wheels will have been spun in vain.

This, sans the Harry Potter allusion, is precisely the view taken in a recent article entitled “The Taxation of Carried Interests in Private Equity Partnerships” at Tax Notes, July 31, 2007, p. 32 by Prof. David A. Weisbach of the University of Chicago who lays out - at least some of – the “horcruxes” left untouched by the proposals:

“The Gergen proposal would treat some distributions to partners as payments for services… The Gergen approach would … be easy to avoid. Using debt rather than limited partnership interests would make any such rules entirely inapplicable because there would be no partnership. If a partnership must be used, the transaction could be documented as the Fleischer/Schmolka structure. That is, if the profits interest were documented as a loan from the limited partners to the general partner (and a contribution of the loaned money), the general partner would unquestionably be receiving a return on contributed capital. The two-percent management fee would be their compensation for services. Thus, the significant complexity that the Gergen approach would introduce would be for naught, or at least very little.

The Levin approach is similar to the Gergen approach but rather than adopting a straight-up allocation rule, it would merely require a reasonable allocation between labor and capital. Similar avoidance mechanisms, such as the use of debt, would be similarly easy to use. Moreover, simply rearranging the labels on the current partnership structure would get around the Levin bill. For example, if the various returns paid to private equity sponsors are combined into a single return, the sponsors could allocate two-thirds of their returns as service income without changing their tax results at all. Auditors would have little basis to challenge such an allocation. More complex restructurings, such as loans from the limited partners to the sponsor who would then contribute the capital to the partnership would make a challenge to the allocations even more difficult. The result would be less efficient and transparent capital structures, an increase in tax controversies, and little or no additional revenue. More subtle rules that attempt to distinguish more accurately would be complex and yet remain inaccurate. This was the very problem faced by Congress when enacting section 707(a)(2)(A). Twenty-three years after passage of this rule, the Treasury has yet to issue regulations because there is no easy way to make the distinction between labor income and capital income. The Levin bill simply glosses over this central problem, hiding its complexities behind a rule that allocations must be reasonable.

The Fleischer/Schmolka approach suffers from similar problems. The underlying rationale is that uneven sharing of returns to capital represents implicit loans that should be recognized. This is a more accurate measure of the return to services than the Gergen approach, but would likely be impossible to implement. It would be necessary to identify when one partner has implicitly loaned funds to another partner and then impute an appropriate cost of capital. If allocations are not straight-up, it would be impossible to identify implicit loans. At a deeper level, the capital accounts system required by the 704(b) regulations does not incorporate time value concepts (except to a limited extent in the substantiality test). Without time value concepts incorporated into capital accounts, there can be all kinds of internal loans among the partners. Attempting to revise the capital accounts rules to incorporate time value concepts, however, is a daunting prospect and would likely make the partnership tax rules entirely unworkable.

To illustrate, a typical private equity partnership uses a hurdle rate. The limited partners get the first 8 or 9 percent of the return. Once that return is achieved, the general partners get an allocation so that the overall return is split 80/20. This could be restated as a nonrecourse loan with a fixed return of eight percent and a contingent return of 80 percent of all profits above 10 percent. With a fixed return of eight percent, it would easily exceed any requirement of paying minimal interest as required by the Fleischer/Schmolka approach. Indeed, if we view the limited partnership interests as financial instruments issued to sophisticated third-party investors, there is no question that they are compensated for the use of capital. Tax rules that treat this return as inadequate would be ignoring the economic realities.”

In short, per the critics, none of the proposals in their current forms seems likely to raise any significant tax revenues. There are just too many places in the partnership tax law to “hide” in that the proposals do not cover.

Enthusiasts who wish to have a further go at this are invited to try to work out solutions to the thicket of issues presented in finding and dealing with more of the tax law “horcruxes”.  For myself, I think I am going to wait until the next Harry Potter movie comes out  or at least for the school season to start again before further agonizing over this issue.

I hope you all enjoyed your summers.
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