The cloture motion failed 57-41.

The carried interest legislation will be back, and I’d guess sooner rather than later.  Revenue offsets are hard to find, and this one is good tax policy.

I was disappointed by Senator Snowe’s speech about payroll taxes on S Corp shareholders.  As with carried interest, the issue is the improper conversion of higher-taxed labor income into low-taxed investment income.  Under current law, the amount of compensation that S Corp shareholders pay themselves is respected so long as it is reasonable.  The whole point of that portion of the bill is that the “reasonable compensation” standard doesn’t work well at all.  If we want to subsidize small business, there are more efficient ways of doing so than by allowing rampant evasion of payroll taxes on labor income by S Corp shareholders.

The Wall Street Journal editorial board needs a tax lawyer.  Or someone who can read a statute.

This morning’s editorial claims that the carried interest legislation will increase the tax rate on “millions of Americans.”  It won’t.  Here’s the editorial:

Democrats want to raise carried-interest taxes from the current 15% rate to the top income tax rate, scheduled to hit 39.6% on January 1. The sales pitch is that this will only whack hedge fund managers and other unsympathetic types. Yet Democrats wrote the law so broadly that it may sweep up millions of Americans in family partnerships.This would be a huge hit to the estimated 6.5 million folks invested in real-estate partnerships, who own assets ranging from a local house to a commercial shopping center. The legislation also potentially hits any partnership invested in certain specified assets, including families who own, say, an auto dealership, fishing boat, construction company or securities.

via The Family Business Revenue Act – WSJ.com.

In fact, the carried interest legislation is much more narrow.  It only affects holds of an “ISPI”–an investment services partnership interest–which means that you advise on buying and selling, manage, or arrange financing for the acquisition of “specified assets”.  Specified assets include securities, real estate held for investment or rental, interests in partnerships, commodities, options, and derivative contracts.  It does not include operating businesses like an auto dealership, fishing boat, or construction company.

Most people who run a family business run an operating business, not an investment management company.  I understand the concern raised in the editorial; once you include real estate in the definition of specified assets, you have to find a way to distinguish between the development of a commercial office building and, say, a restaurant.  But because the statute only reaches real estate held for rental or investment, the owner of a restaurant isn’t going to be touched.

As to the scope of the bill generally: if I were drafting the bill, I would have limited the scope to investment management firms, tying the definition to the 40 Act.  There’s no particular reason why real estate developers (or anyone else) should pay tax at a lower rate on their labor income than other high-income earners, but the equity, efficiency, and distributive justice concerns are so glaring in private equity, and I think it’s easier to fix one problem at a time.

But back in 2007, lobbyists for private equity pushed to *expand* the definition to include real estate and venture capital.  The PE strategy assumed that the broader the scope of the bill, the less likely it is to succeed.  They were right in 2007.  We’ll see what happens this week.

The UK is also addressing carried interest.  Their approach is simply to raise the capital gains rate to 28%; as in the US, the private equity firms are threatening to expatriate.  They won’t.

In its inaugural stab at reining in one of the highest deficits in the world, the U.K.’s new coalition government said it would raise capital gains tax, which taxes profit made by individuals on property and assets, by 10% to 28% with effect from Wednesday. The tax is payable on profit above GBP10,000 a year.

But the rise wasn’t as large as feared by many private equity executives who have to pay CGT on the carried interest, or the share of profits that fund managers receive as part of their compensation.

“It is a big increase but it could have been a lot worse–many were expecting a hike to 40% or even 50%,” said Caspar Noble, a partner in the tax group at Ernst & Young.

via UK Budget Unlikely to Drive Private Equity Bosses Away – WSJ.com.

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.

Not a bad analogy.

It may not have been as big an unexpected defeat as Spain’s loss to Switzerland in the World Cup or as ridiculous a spectacle as the debate in Washington over what exactly the word “plume” means, but the U.S. Senate’s struggles to pass the tax extenders’ bill – which contains an increase in taxes on carried interest – nonetheless caused some gasps and shouts of “Ole!” in our little corner of the office. The twists in this saga have been harder to follow than the edges of an M.C. Escher image, but the latest – short of whatever backroom dealing we’re not privy to – is that Democrats were four votes short of ending debate on the scaled-back bill they’ve suggested as of Thursday night. The path forward from here is not clear, writes the Huffington Post.

via The Week In Private Equity: Of Carried Interest And M.C. Escher – Private Equity Beat – WSJ.

The carried interest legislation, which is attached the the tax extenders bill, is still alive in the Senate (I think).  The latest language, an amendment to the bill offered by Baucus, is available here.

The latest version would tax carried interest as 75% ordinary income and 25% capital gain.  If the underlying assets of the partnership have been held for 5 years or longer, allocations would be treated as 50% ordinary income and 50% capital gain.  The favorable rate for 5 year assets especially helps venture capital firms and some private equity and real estate firms.

The private equity industry has been aggressively fighting to change the bill’s treatment of a sale of a partnership interest (proposed section 710(b)), which they call an enterprise value tax.  The latest version of the bill would extend a 50/50 blended rate to the portion of the sales proceeds attributable to goodwill.  I’ll try to post more about this later.

CV as of April 22, 2010.

I’ve posted a draft of my paper on regulatory arbitrage.

Here’s the abstract:

Most of us share a vague intuition that the rich, sophisticated, well-advised, and politically connected somehow game the system to avoid regulatory burdens the rest of us comply with. The intuition is correct; this Article explains how it’s done.

Regulatory gamesmanship typically relies on a planning technique known as regulatory arbitrage, which occurs when parties take advantage of a gap between the economics of a deal and its regulatory treatment, restructuring the deal to reduce or avoid regulatory costs without unduly altering the underlying economics of the deal. This Article provides the first comprehensive theory of regulatory arbitrage, identifying the conditions under which arbitrage takes place and the various legal, business, professional, ethical, and political constraints on arbitrage. This theoretical framework reveals how regulatory arbitrage distorts regulatory competition, shifts the incidence of regulatory costs, and fosters a lack of transparency and accountability that undermines the rule of law.

You can download the paper here.

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