private equity and the so-called “enterprise value tax”
There’s no such thing as an “enterprise value tax.” The carried interest legislation includes a provision that treats a portion of the sales proceeds from the sale of an investment services partnership interest as ordinary income. The private equity industry has labelled this the “enterprise value tax,” as if it were a new, punitive tax on private equity management companies. It is not.
Selling partners often recognize some ordinary income. The tax code often requires selling partners to recognize a mix of ordinary income and capital gains when they sell a partnership interest. Section 751 of the code identifies “hot assets,” such as inventory and unrealized receivables, and forces selling partners to recognize ordinary income to the extent that gain is attributable to the value of those assets. The carried interest legislation merely applies the principles of partnership tax, including section 751, to the investment services context.
Commentators misunderstand how this works. Earlier this week, for example, Professor Hubbard suggested that a private equity management company should be treated the same as a car dealership, implying that the entire gain should be treated as capital gain. But if a partner in a car dealership sold his stake, the value of the cars on the lot (inventory), existing sales contracts, the franchise value, trade names, and similar items would all generate ordinary income. It is simply not the case that selling partners always (or even often) get taxed entirely at capital gains rates.
Entity or aggregate. So how should the tax code deal with the sale of an investment services partnership interest? The premise of the carried interest legislation is that carried interest represents a return on labor, not investment capital, and so it should be taxed, at least in part, at ordinary income rates. The current version of the bill taxes carried interest allocations as 75% ordinary income and 25% capital gains, or 50/50 if the underlying assets have been held for 5 years. If we took a pure “entity” approach, monetizing carried interest would generate capital gains, thus providing an easy loophole out of section 710 for selling partners. A pure “aggregate” approach would look through the partnership at the underlying assets to determine the character of the income to the selling partner.
Institutional context. What is the right approach? In my view, the peculiar nature of services partnerships like PE management companies require us to look carefully at the business being sold. What exactly are the partners selling? When the founders and employees of Blackstone, Fortress, or the other PE management companies sell a stake to the public or outside investors, they are selling three different streams of income: (1) expected carried interest allocations from existing investment funds, (2) the value of management contracts from managing other people’s money and providing investment advice (including management fees from the limited partners of its funds), and (3) goodwill. Expected carried interest allocations, like unrealized receivables, should generate ordinary income. So too should management contracts, although current law often allows conversion of future management fees into capital gain. (Management contracts that can be broken on 30 days notice are not treated as ordinary income items under current law, although they probably should be.)
What about goodwill? The goodwill portion of the business represents the extent to which the value of the business exceeds the liquidation value of its assets. In many cases, the goodwill portion will amount to half the value of the business or even more. Why? Blackstone, KKR, Carlyle and the other PE management companies have little in the way of hard assets, software, patents, factories and the like. Instead, they have created impressive human capital infrastructures — expertise and networks of contacts on both sides of the deal — the investors (such as pension funds and university endowments) who have capital, and the ability to locate and romance target companies. Allowing the founders and employees of the management company to monetize their human capital into capital gain would violate the policy behind section 751, which seeks to prevent the easy conversion of labor income into capital gain.
The Baucus amendment. The current version of the carried interest legislation — the Baucus amendment of June 16, 2010 — takes a modified entity/aggregate approach. Rather than simply treat carried interest as a “hot asset” and treat goodwill as generating capital gain, the legislation would treat goodwill as generating 50% ordinary income and 50% capital gain.
Why rough justice is a good approach. The private equity industry has objected that this “rough justice” approach is worse than the usual approach of section 751, which identifies ordinary income items and then allows capital gain for the balance. The “rough justice” approach is sensible, however, for a couple of reasons.
Liquidation value doesn’t work. First, applying section 751 as it reads today will produce valuations that understate the valuation of carried interest and overstate the amount of goodwill. Because carried interest allocations tend to come at the end of the life of a fund, merely treating the liquidation value of carried interest items as ordinary income will understate the true value of expected carried interest allocations. Recall the whole reason we need section 710: when a GP receives a profits interest in a partnership at the commencement of the fund, the current liquidation value is zero, and the GP recognizes no income under section 83 even though the partnership interest is obviously valuable and provided in exchange for services.
Mark-to-market value isn’t great either. Second, even a mark-to-market valuation understates the value of carried interest. As a fund progresses, the value of the fund is subject to the “J-curve” effect — the value tends to decrease slowly for several years, then increase sharply as portfolio companies are sold. Again, using the estimated current market value of the portfolio companies will underestimate the true value of the expected carried interest allocation (i.e. the value a willing buyer would pay for the carried interest allocation assuming the portfolio companies are held until exit).
Judicial doctrine. Third, even before section 751, courts sometimes disallowed capital gains treatment when service partners monetized a stream of services income. Rather than rely on the uncertainty of judicial application of these old doctrines, the Baucus amendment would provide a clear rule.
The “Blackstone” arbitrage. Fourth, taxing a portion of the sales proceeds as ordinary income is necessary to take some of the air out of the tax arbitrage created when selling partners pay capital gains rates on goodwill, while buyer get to amortize the goodwill over 15 years at ordinary rates. Because the selling partners enter into a tax receivable agreement with the buyers, the selling partners recapture the tax benefit created by the goodwill and, on a present value basis, can almost come out ahead. A higher tax rate on the “goodwill” is necessary to prevent tax-motivated sales.
How this will work in practice. Assume the current bill passes. Carlyle, KKR, and some other PE firms plan to go public in the next few years. When the employees and founders sell their equity, about 1/4 of the value of the firm (carried interest) will generate ordinary income, about 1/4 of the value of the firm (management contracts) will generate mostly capital gain, and about 1/2 of the value of the firm (goodwill) will generate 50/50 treatment. So, if a founder or employee sells a $1 billion stake to the public, he will pay tax at about a blended 25% rate (or 30% if both CG and OI rates go up, as expected). That’s $250 million in income tax, assuming a zero basis in his partnership interest. But the buyer (the public holding company) will get to amortize the goodwill portion ($500 million) at ordinary rates over 15 years, creating a tax benefit of about $100 million, perhaps more if the management contracts are treated as 197 intangibles.
Summary. The current version of the carried interest legislation contains no “enterprise value tax”. It merely applies longstanding principles of partnership tax law to allow selling partners of a service partnership to convert only a portion of their labor income into capital gain. While, from an academic point of view, I think the entire return on labor income should be taxed at ordinary rates, the 50/50 approach of the current bill is consistent with its blended rate approach.
This is already a long post, but I’ll try to update it this week if it looks like the carried interest legislation is moving forward. I’m still working on this issue, and I welcome comments or corrections.