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TAX 'CARRIED INTERESTS' AS ORDINARY INCOME - BECAUSE PARTNERSHIP TAX LAW ISN'T HARD ENOUGH?

August 02, 2007

The Senate held hearings this week on the taxation of "carried interests" in investment partnerships. Congress needs more money for things like corn subsidies - after all, corn prices are high, so corn subsidies need to keep pace. Fair's fair.

Believe it or not, it's not just a New York thing. There are Iowans doing these deals too (take note, Senator Grassley).

Here's how carried interests work. An investor group provides funds to buy a corporation, or multiple companies. We'll just say they invest $10 million. They give the money to investment managers who will invest the money for the group. While compensation arrangements vary, typically the investor group will get an annual fee of 2% of the value of the company and a "profits interest" or "carried interest" of 20% of the return generated by the investment.

The managers use the $10 million to buy a company. The company grows in value over five years by $2 million each year, net of enough dividends to pay the 2% annual fee. The company is sold for $20 million after the fifth year, generating a $10 million long-term capital gain.

The tax returns of the partners and managers reflect the following items from the fund:

Click table to enlarge

Our senators cast their greedy little eyes on the $2 million capital gain that the fund managers get at the end of Year 5. Because they share 20% of the entity's profits, the managers share 20% of the capital gain. The managers pay a maximum federal rate of 15% on the capital gain under current tax law.

This is an unremarkable result from a technical tax point of view. In 1993 the IRS ruled that a "profits interest" in a partnership can be granted to a taxpayer without triggering current tax. A profits interest gives the recipient an interest only in future growth of a partnership. If the partnership is liquidated the day after a profits interest is issued, then the owner of the profits interest should in theory get nothing. Going forward, the recipient of the profits intesest is treated as a full partner in the partnership's growth. If the partnership generates capital gains, the managers get a K-1 reporting their share of the gains.

Some politicians don't like this result, though, because they say the managers' share of the appreciation is "compensation," like wages, and should be taxed as ordinary income at rates up to 35%.

While some smart academics have policy objections to this result, the politicians just seem upset with the idea that a small set of rich people are getting a better tax deal on their compensation than they are Joe Lunchbox.

Outside academia, there's less enthusiasm. The non-enthusiasm is justified.

WHAT'S THE PROBLEM? IS THE SOLUTION WORSE?

For starters, this result is not unique to the partnership area. It is very similar to the result when an employee makes a "Section 83(b) election" on the receipt of restricted stock from an employer. It's not all that different from the desired results of incentive stock options, without the AMT nightmares.

If you assume that the result is wrong, what do you do about it? The politicians probably would like to just tax the managers's share as ordinary income, but if you do that, how do you limit it to equity funds? It's hard to see how to draft it in a way that would either be easily avoided or that wouldn't drag in all sorts of other partnership arrangements, like family investment partnerships. This would also create an income and deduction mismatch, unless you taxed the investment partners on 100% of the capital gain and gave them an ordinary deduction for the carried interest, and made sure the ordinary deduction was exempt from the 2% of AGI floor on invesment expenses.

Another proposed solution would be to tax the managers on the "option value" of the profits interest. This would require the application of option pricing theory to non-public companies - never an easy task. Still another proposal, by one of the more active academics in this area, would apply a "cost of capital" computation to convert a portion of the carried interest to ordinary income.

These are the kinds of proposals that would only be made by somebody who isn't actually trying to run a business or prepare real tax returns.Subchapter K, the partnership rules, are notoriously complex. Only an academic would seek ways to make them worse.

Ultimately, it's not clear that there is a problem here that needs solving. So what if the management ultimately gets capital gains? As long as the tax law provides capital gain rates in the first place, why should the managers be left out? The carried interest is a gamble; they could (and often do) end up with no gain at all. The annual fee is already ordinary income; it seems like rough justice that the "safe" part of the management compensation is ordinary, while the risky part is capital gain.

As far as the tax law is concerned, the managers are partners. Trying to make the tax results from one set of partners differ from another requires a lot of arbitrary distinctions and a lot of complexity. It's not worth it to muck up an already baroque part of the tax law just because politicians and academics find hedge fund managers distasteful.

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