Taxing Founders’ Stock (work in progress)

Founders of a start-up usually take common stock as a large portion of their compensation for current and future labor efforts. Getting paid in founders’ stock allows entrepreneurs to defer paying tax and – more importantly – allows them to pay tax at the long-term capital gains rate. Politicians, entrepreneurs, and many academics claim that the favorable tax treatment of founders’ stock is an effective method of subsidizing entrepreneurship.

This Article questions the prevailing view that we should tax founders at a low rate. The economic efficiency case for a tax preference for founders’ stock is weak. Tax policy is an ineffective policy instrument for subsidizing entrepreneurship; tax has an effect on entrepreneurial entry, but the effect is small. Tax is less important than geographic, cultural, and business factors. And tax is less important than other elements of the legal infrastructure, such as immigration policy, employment law, and securities law.

The case for reform is compelling. Taxing founders at a low rate is a conspicuous loophole in the fabric of our progressive income tax system, uniquely undermining our shared commitment to equal opportunity and distributive justice. Founders’ stock is often bequeathed to heirs who receive a step up in basis, allowing founders to avoid the income tax altogether, leaving a legacy of dynastic wealth subject only to the rather dodgy application of the estate tax.

While it would be normatively desirable to eliminate the tax subsidy and instead tax gains from founders’ stock at the same rate as labor income, fixing the problem is not easy. I offer possible solutions that policymakers might consider as part of a broader tax reform and deficit reduction effort.

Regulatory Arbitrage (Texas Law Review, forthcoming 2010)

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.

A Theory of Taxing Sovereign Wealth, 84 NYU Law Review 440 (2009)

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.

Taxing Blackstone, 61 Tax Law Review 89 (2008)

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.

Two and Twenty: Taxing Partnership Profits in Private Equity Funds, 83 NYU Law Review 1 (2008)

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 adoption of 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.

Brand New Deal: The Branding Effect of Corporate Deal Structures, 104 Michigan Law Review 1581 (2006).

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 dealwas 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.

The Missing Preferred Return, 31 Journal of Corporation Law 77 (2005)

Managers of buyout funds typically offer their investors an 8% preferred return on their investment before they take a share of any additional profits. Venture capitalists, on the other hand, rarely offer a preferred return. Instead, VCs take their cut from the first dollar of nominal profits. This disparity between venture funds and buyout funds is especially striking because the contracts that determine fund organization and compensation are otherwise very similar. The missing preferred return might suggest that agency costs pose a larger problem in venture capital than previously thought. Is the missing preferred return evidence, perhaps, that VCs are camouflaging rent extraction from investors?

This Article argues that the missing preferred return is evidence that venture capital compensation practices do not properly align incentives. Making VC pay subject to a preferred return would help investors screen out bad VCs and would motivate VCs more effectively when they find, court, and negotiate with entrepreneurs. This positive effect that the preferred return may have on deal flow incentives may be less important for VCs with strong reputations. Even for elite VCs, however, the status quo appears to be inefficient, albeit in a different way. If a fund declines in value in its early years, as is usually the case, the option-like feature of VC pay distorts incentives. Compensating VCs with a percentage of the fund, rather than just a percentage of the profits, would eliminate this distortion of incentives. Thus, the current industry practice is puzzling. None of the usual suspects like bargaining power, boardroom culture, camouflaging rent extraction or cognitive bias offers an entirely satisfactory explanation. Only by peering into a dark corner of the tax law can we fully understand the status quo.

The tax law encourages venture capital funds to adopt a compensation design that misaligns incentives but still maximizes after-tax income for all parties. Specifically, by not recognizing the receipt of a profits interest in a partnership as compensation, and by treating management fees as ordinary income but treating distributions from the carried interest as capital gain, the tax law encourages funds to maximize the amount of compensation paid in the form of a profits interest. One way to do this is to eliminate the preferred return, thereby increasing the present value of the carried interest, which in turn allows investors to pay lower tax-inefficient management fees.

The Rational Exuberance of Structuring Venture Capital Start-Ups, 57 Tax Law Review 137 (2004)

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.