Could President Obama End Carried Interests Without Congress ?

Originally Published on forbes.com on August 23rd,2011

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Much of the debate about the favorable tax treatment of hedge fund managers and venture capitalists is ideological.  There is either resentment or a spirited defense of the free-enterprise system.  There is little or no understanding as to what makes the tax break work in most discussions.  I suspect that many people think there must be a section of the law dedicated to hedge fund managers that they managed to slip into a defense bill or something.  Much as I love conspiracy theories, it is nothing like that.  The favorable treatment is based on fundamental principles of partnership taxation.  I explained that here.

My big concern is that the legislative fix will do collateral damage.  It adds a fairly long  section to the Internal Revenue Code and creates a new category.  It is also not limited to hedge fund managers and venture capitalists – neither of which are tax terms.  I explained that here.

When I started this my editor, Janet Novack, pointed me to a piece in the Wall Street Journal by Laura Sanders.  It was mainly about comments made by Michael Graetz, a former treasury official and now tax professor at Columbia University.  He pointed to a tax court decision that was won by venture capitalist Todd A. Dagres.  I had mentioned the case previously.  Mr. Dagres had roughly a 2 million dollar salary.  He had about 40 milllion in long term gains  mostly from carried interests.  He had lost over 3.5 million on a loan that he had made to somebody who helped find him deals.  He thought he should get an ordinary deduction for that and the Court agreed, because all that capital gain that he had was really business income and the loan was related to that.  Professor Graetz indicated that following that logic all the income should be ordinary and the IRS should turn this minor defeat into a major triumph.  I wouldn’t want to be Mr. Dagres at the venture capital picnic if Professor Graetz is right and the IRS picks up on it.  “You killed carried interests so you could save a lousy five hundred grand or so ? Gimme a break.”

I was criticized on another site (If you are going to knock me at least do it on Forbes) for being unclear as to what my thoughts were on the merits of this particular reform.  That is whether it is a good thing or a bad thing that hedge fund managers and venture capitalists pay capital gains on their share of their funds capital gains as opposed to getting paid some sort of ordinary incomeincentive bonus.  The unclarity comes from my tendency to satirize the overblown rhetoric that gets into these discussions.  I started off my most recent piece with “Carried interest is the nefarious concept that the evil hedge fund managers use …..”  I think the other person who read that piece might have liked it though.  So I will make my position clear on whether it is a good idea or a bad idea to make hedge fund managers and venture capitalitspay taxes at ordinary rates on their carried interest gains.  I have none.

With respect to the proposed legislation, I think that it is very bad legislation.  On the other hand it will mean more work for people like me, so it can’t be all that bad.

There is, however, an approach that could end the benefit without adding three thousand words to the Code.  It does not require the cooperation of Congress.  There is a regulation 1.701-2 that governs using the partnership form in a way that is inconsistent with its purpose to:

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

The regulation goes on to list good and bad reasons for using the partnership form. Venture capital funds and hedge funds do not have to be organized as partnerships in order to do what they do.  You could have some sort of co-ownership.  Frequently people prefer co-ownerships, since they can often be simpler.  Why do venture capital funds and hedge funds organize as partnerships ? Well one reason is so that the managers can get captial gains treatment on their incentive compensation.  If that is not a good reason, the IRS can add it to the “bad partnership” list and it is done.

That approach is totally in the executive branch.  I doubt it is as simple as the President getting on the phone to the Commissioner and telling him he wants him to add another example to the list in 1.701-2.  There is probably a political calculus to this that is beyond my feeble understanding.  By making it another girdlock issue he gets to rail against Congress.  Congress gets to say they are standing up for free enterprise.  If the regulations were tweaked in the way I suggested there would be litigation.  One way to do it might be for it to be prospective so that it would only apply to new deals.

There are good arguments on both sides of the issue.  In some ways venture capitalists are like any entrepeneur who starts a business without much of his own capital and eventually gets to a “liquidity event”.  Of course they are not exactly like that, but I am concerned that the new Code Section 710 will create a new gray area.  The concern about the brain drain out of venture capital if they no longer get capital gain treatment on their incentive compensation is not one that I share.  If we can get more brain power into professions by letting them recognize their income as capital gains we should start with elementary education.  Although since they don’t make enough to benefit very much maybe we should do it with internal medicine or pediatrics.