Can Carried Interest be Fixed Without Legislation ? Part 3 of a Two Part Series.

Originally Published on forbes.com on August 22nd,2011

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Carried interest is the nefarious concept that the evil hedge managers use  to turn their service income into capital gains.  The problem with combating this great evil is that it is based on a fundamental principle of partnership taxation.  The nature of income is determined at the entity level and the partner stands in the shoes of the partnership.  The proposed fix – Code Section 710 is about 3,000 words long.  It is ridiculously complicated and affects many more people than hedge fund managers.  On the bright side, it could be appropriatly titled the Partnership Tax Expert FullEmployment Act of 2011.

  When I told Janet Novack, my editor, that I was working on this she asked me if I thought the problem could be fixed administratively.  She referred me to an article about it.  I wrote a post on it.  I’m skeptical that the rationale  mentioned there would serve.

Now I am going to explain to you the world of partnership taxation by way of an analogy.  If partnership taxation were a religion, my friend,CharleyEgerton, would be a bishop – no a cardinal. He just completed a term as chair of the ABA Tax Section.  Previously he had chaired the Tax Section’s partnership committee.  Whenever I call Charley with a question he almost always says “Did you check McKee?”  He is referring to Federal Taxation of Partnerships and Partners.  The lead author is William S. McKee.  In my analogy Mr. McKee is the pope.  Myself I’m an altar boy, but one of the eighth graders who could sleep late on Sunday, because he had the 12 O’clock Mass.  Priesthood requires at least a law degree and anadvanced degree in taxation.  I am so pathetic.  No law degree and my masters is in applied mathematics.

So I went looking for what Mr. Mckee has had to say on the subject lately.  In the process I foundthis article.  It’s in a college newspaper or magazine or something.  Whatever it is it’s run by the kids.  The college used to be a seminary for congregational ministers.  I hear it’s a pretty good school, not too far from Boston College.   They play Holy Cross in football so it’s not a bunch of stupid jocks.  At any rate the article is recent, it covers the issue in depth and it mentions Mr. McKee, if only in a footnote, so it has some credibility.  The article discuss seven methods for solving carried interest.  If you want to make an intelligent comment on this issue you should read the article, two or three times.  If you don’t understand it, shut up.

I don’t agree that they have found the best solution.  I don’t think they understand the realities of maintaining captial accounts.  That’s the amusing thing about the partnership religion.  The priests and the bishops talk about all these concepts. It’s the altar boys like me that actually put numbers on returns.  Of course it’s the fourth graders doing that.  I just review the returns and make obscure comments, check Mckee and maybe once every couple of months call Charley Egerton.

The Solution ?

I believe though that I have found the solution to the problem and that it does not require legislation.  It will also not have implications outside the world of investment partnersips.  I remeber when Reg. 1.701-2 came out.  It is titled Anit-abuse rule.  (It has nothing to do with my previous post on42nd Street). I was on the AICPA Partnership Division Tax Committee (Hey, it impressed one of our peer reviewers once).  The other members were wailing and gnashing their teeth.  The regulation explains that:

Subchapter K is intended to permit taxpayers to conduct joint business (including investment) activities through a flexible economic arrangement without incurring an entity-level tax

The provisions of subchapter K and the regulations thereunder must be applied in a manner that is consistent with the intent of subchapter K as set forth in paragraph (a) of this section (intent of subchapter K). Accordingly, if a partnership is formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the present value of the partners’ aggregate federal tax liability in a manner that is inconsistent with the intent of subchapter K, the Commissioner can recast the transaction for federal tax purposes, as appropriate to achieve tax results that are consistent with the intent of subchapter K, in light of the applicable statutory and regulatory provisions and the pertinent facts and circumstances. Thus, even though the transaction may fall within the literal words of a particular statutory or regulatory provision, the Commissioner can determine, based on the particular facts and circumstances, that to achieve tax results that are consistent with the intent of subchapter K

The regulation then goes on to give examples of partnerships that either do (nice partnership) or do not (bad partnerhsip)use subchapter K as it was intended.  I immediatly found Example 6:

A and B, high-bracket taxpayers, and X, a corporation with net operating loss carryforwards, form general partnership PRS to own and operate a building that qualifies for the low-income housing credit provided by section 42. - Nice partnership

I decided these regulations were something I didn’t have to worry about it.  In retrospect I see why the national firm guys and gals were worried.  They should have paid even more attention and we might not have had debacles like Son of Boss.

So you are starting a venture capital fund.  Why not organize it as some sort of co-ownership arrangement, some sort of trust with the managers getting incentive compensation ? Well. Uh.  We want a partnership so the managers can get capital gain treatment on their incentive compensation.  The Commissioner can just add that as an example of a bad partnership.  Why doesn’t the President order that ? (I don’t know if it works that way).I would say do it prospectively for partnerships formed after a certain date.

Why Killing Carried Interest is Very Bad
This is discussed in the article.  If you start a business even though you invest very little, when you sell out you get capital gains (generally).  The article notes that some of the carried interest return is like that and some is for services.  It suggests teasing those two pieces apart.  The concern is that these guys are doing such a fantastic job of managing our economy that we don’t want to demoralize them by making them pay taxes at ordinary rates on their very contingent bonuses.  Look at Mr. Dagres, whose victory some think could turn into a disaster for the industry. Over 90% of his compensation was contingent.  He might be demoralized and we’ll lose the benefit of his guidance.  Well.  What is it that he is going to go into where he can match his 2 million dollar salary if he is disgusted because his 40 million dollar bonus is taxed as ordinary income ?  Pediatrics ? Education ? Public accounting ? Blogging ? He doesn’t have any experience in those fields.  It would take him years to get back to his old salary

What’s In it For Me ?

Unlike the other proposals, this one doesn’t make me salivate.  Fewer partnership returns to prepare.  Fewer complications.  Less need to check McKee or call Charley Egerton.  Half our laity would be converting to a different subchapter.  I’m really not worried.  Just in case, though, I’ll try to improve blog quality.