A number of academics and pay consultants say that carried interest should be taxed as ordinary income. They contend that fund managers receive carried interest as compensation for a service performed—managing other people’s money—making the carried interest nothing more than labor wages.

University of Colorado tax law professor Victor Fleischer, whose views caught the attention of Congress two years ago, agrees with this approach. He notes that profits earned by managers from their own money invested in their funds—typically a small percentage of the total fund size—are appropriately taxed at capital-gains rates. But he said the portion of pay managers get for investing other people’s money should be taxed at ordinary income rates, just like other forms of salary.

“It’s amazing to me that at the same time the U.K. is imposing a 50% excise tax on bankers’ bonuses, the private-equity guys aren’t even willing to pay the usual ordinary income rate,” Mr. Fleischer said. “You would think they would recognize a fair deal when it’s offered.”

Link to the article

Private equity fund managers take a share of the profits of the partnership as the equity portion of their compensation. The tax rules for compensating general partners create a planning opportunity for managers who receive the industry standard “two and twenty” (a two percent management fee and twenty percent profits interest). By taking a portion of their pay in the form of partnership profits, fund managers defer income derived from their labor efforts and convert it from ordinary income into long-term capital gain. This quirk in the tax law allows some of the richest workers in the country to pay tax on their labor income at a low rate.  Changes in the investment world—the growth of private equity funds, the adoptionof portable alpha strategies by institutional investors, and aggressive tax planning—suggest that reconsideration of the partnership profits puzzle is overdue.

While there is ample room for disagreement about the scope and mechanics of the reform alternatives, this Article establishes that the status quo is an untenable position as a matter of tax policy. Among the various alternatives, perhaps the best starting point is a baseline rule that would treat carried interest distributions as ordinary income. Alternatively, Congress could adopt a more complex “Cost-of-Capital Method” that would convert a portion of carried interest into ordinary income on an annual basis, or Congress could allow fund managers to elect into either the ordinary income or “Cost-of-Capital Method.” While this Article suggests that treating distributions as ordinary income may be the best, most flexible approach, any of these alternatives would be superior to the status quo. These alternatives would tax carried interest distributions to fund managers in a manner that more closely matches how our tax system treats other forms of compensation, thereby improving economic efficiency and discouraging wasteful regulatory gamesmanship. These changes would also reconcile private equity compensation with our progressive tax system and widely held principles of distributive justice.

Download Full Paper: Two and Twenty

This Essay analyzes the “Blackstone Bill,” which would treat Blackstone and other publicly-traded private equity firms as corporations for tax purposes. Earlier this year, the Blackstone IPO fueled a heated, somewhat confusing debate about taxing private equity. This Essay seeks to clarify what the legislation will accomplish, and what it won’t.

There are two ways of looking at the Blackstone Bill. The first way is as a substantive change in the tax law. Specifically, the bill may be viewed as a rifleshot approach to changing the tax treatment of carried interest. The second way is to think of the bill as a mechanical correction of the publicly-traded partnership rules. Specifically, the bill may be viewed as a technocratic response to the regulatory gamesmanship of Blackstone’s deal structure, which allows it to avoid the corporate tax that other, similarly-situated financial intermediaries pay.

In terms of a change in the substantive tax treatment of carried interest, the merits of the Blackstone Bill are questionable. The efficiency and distributive consequences are unclear; the revenue potential is indeterminate. The bill fails to achieve what we ultimately want: taxing the returns from managing financial assets consistently regardless of the form in which the business is conducted.

But the Blackstone Bill is nonetheless defensible as a response to aggressive regulatory gamesmanship. To put it more provocatively, the bill is justifiable because the Blackstone IPO structure is offensive to the rule of law values on which our tax system relies.

Download the full paper: Taxing Blackstone.

Branding is an unappreciated feature of contract design. Corporate finance scholars generally assume that consumers focus on product attributes like price, quality, durability, and resale value. But consumers choose brands, not just product attributes. This Article claims that the legal infrastructure of deals sometimes has a branding effect – that is, an effect on the brand image of the company. Deal structure affects the atmospherics of the brand.

I explore this link between deal structure and brand image by first examining the Google IPO from last summer. From a traditional corporate finance perspective, the goal of a properly structured IPO is to manage the information asymmetry between issuer and investors and to lower the cost of capital. From this perspective, the success of the Google deal is questionable. Few would call the deal elegant or efficient. But this is not really what the Google IPO structure was about, or at least it is not the full story. When Google structured its IPO as an auction, it reinforced its image as an innovative, egalitarian, playful, trustworthy company. Talking about Google’s IPO makes you want to use Google’s products. By that measure, the deal was a success.

I also examine the branding effects of three other deals: the Ben & Jerry’s public offering in 1984, which sold stock only to Vermonters; Steve Jobs’s contract with Apple, which entitles him to cash salary of exactly one dollar; and Stanley Works’ failed attempt to reincorporate in Bermuda to minimize its tax liability.

Finally, I conceptualize the role of branding as it relates to deal structure. Deal structure may be a useful advertising medium for companies targeting early adopters of cult-like products. Certain legal events in the lifecycle of the company – what I call branding moments – provide opportunities for firms to signal company values to these early adopters.

Download the full paper: Brand New Deal

Sovereign wealth funds enjoy an exemption from tax under §892 of the tax code. This anachronistic provision offers an unconditional tax exemption when a foreign sovereign earns income from noncommercial activities in the United States. The Treasury regulations accompanying §892 define noncommercial activity broadly, encompassing both traditional portfolio investing and more aggressive, strategic equity investments. The tax exemption, which was first enacted in 1917, reflects an expansive view of the international law doctrine of sovereign immunity that the United States (and other countries) discarded fifty years ago in other contexts.  Because §892 was not written with sovereign wealth funds in mind, the policy rationale for this generous tax treatment has not been closely examined in the academic literature.

This Article provides a framework for analyzing the taxation of sovereign wealth.  I start from a baseline norm of “sovereign tax neutrality,” which departs from the current regime under §892 by treating the investment income of foreign sovereigns no better and no worse than foreign private investors’ income and by favoring no one nation over another. Whether we should depart from this norm depends on several factors, including what external costs and benefits are created by sovereign wealth investment, whether tax or other regulatory instruments are superior methods of attracting investment or addressing harms, and which domestic political institutions are best suited to implement foreign policy. I then consider whether we should impose an excise tax that would discourage sovereign wealth fund investments in U.S. companies. This tax might be designed to complement nontax economic and foreign policy goals by discouraging investments by funds that fail to comply with best practices for transparency and accountability.

The case for repealing the existing tax subsidy is strong. We should tax sovereign wealth funds as if they were private foreign corporations; there is no compelling reason to subsidize sovereign wealth. At the same time, my analysis suggests that policymakers should be cautious about going any further: An excise tax may not be the optimal regulatory instrument for managing the special risks posed by sovereign wealth funds.

Download full paper: Taxing Sovereign Wealth

A couple of years ago, Victor Fleischer published a research paper that helped put the entire private equity industry on the defensive about the taxes they paid (or didn’t pay).

Now, Mr. Fleischer, a professor at the University of Illinois College of Law, may be stirring up a new controversy. This one relates to sovereign wealth funds, government-controlled investment pools that have been pumping billions of dollars into troubled American companies.

The issue, according to a post Mr. Fleischer wrote this week for the Conglomerate blog, is that sovereign wealth funds pay no taxes on passive investments made in the United States.

Read the full story.

By ANDREW ROSS SORKIN

MORE than a year ago, Victor Fleischer, an untenured professor at the University of Illinois College of Law, finished a draft of a paper about the tax treatment of private equity.

At the time, he was just hoping to get the paper published. Taxes are an unglamorous topic, and, worse, Mr. Fleischer’s paper was about the arcane intricacies of “carried interest,” hardly a household term. The paper argues that private equity managers are using a tax loophole to pay capital gains rates of 15 percent on carried interest, instead of the ordinary income tax rate of 35 percent. Carried interest, which comes out of a private equity fund’s profit, provides most of the compensation for fund managers.

The paper eventually landed with some Congressional staff members, who were looking for ways to pay for a rollback in the alternative minimum tax. Today, carried interest is front-page news. It is the subject of hearings on Capitol Hill and the focus of a proposed bill, whose backers include Representative Sander Levin, Democrat of Michigan, that could cost executives in the buyout industry more than $4 billion.

. . .

Read the full story.

This Article takes the bursting of the dot com bubble as an opportunity to reevaluate the tax structure of venture capital startups. By organizing startups as corporations rather than as partnerships, investors and entrepreneurs seem to leave money on the table by failing to fully use tax losses – especially since the vast majority of startups fail. Conventional wisdom attributes the lack of attention paid to losses to a “gambler’s mentality” or optimism bias. I argue here that the use of the corporate form is, in fact, rational, or at least that there is a method to the madness.

I make four main points. First, the tax losses are not as valuable as they might seem; tax rules prohibit many investors from capturing the full benefit of the losses. Second, the VC professionals who structure the deals do not personally share in the losses, so they have little reason to care about the tax effects of the losses. Third, gains are taxed more favorably if the startup is organized as a corporation from the outset, and again, this favorable treatment of gains is especially attractive to the VC professionals – further evidence that agency costs may be playing a role here. Fourth, corporations are less complex than partnerships: organizing as a corporation minimizes legal costs and simplifies employee compensation and exit strategy.

Download the full paper: Rational Exuberance.

The House has voted (again) to change the treatment of carried interest earned from managing investment funds from capital gain to ordinary income.  I’ve heard the bill has a better shot in the Senate this time than in 2007, but one shouldn’t underestimate the capacity of the Private Equity Council to lobby for the status quo.

House Votes to Raise Fund Managers’ Taxes – DealBook Blog – NYTimes.com.

I was on NPR’s On Point today – my segment begins around 23:30.

Peter Brooke: Private Equity Now | WBUR and NPR – On Point with Tom Ashbrook.

I was pleased to hear Mr. Brooke agree with me that paying tax on carried interest at 15% wasn’t appropriate.  In fact, we seemed to agree about an awful lot.