Hedge Fund Managers - Hoist on Their Own Petard ?

Originally Published on forbes.com on August 20th,2011

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This is an intermission in my two part series on the tax magic of hedge fund managers, the proposal to fix the perceived abuse and the collateral damage that the proposal would do.  When I told my editor,Janet Novack, that I was going to be working on this she asked me:

Do you think that they’ll try to solve carried interest administratively the way my buddy Laura Saunders suggested in the WSJ they’d do?

My thought was.  How in the world could they do that ?  As I noted in my last piece the tax benefits that hedge fund managers receive flow from very basic principles of partnership taxation.   I couldn’t imagine how the IRS could write a regulation consistent with the Code that would change the result.  Clearly I am not alone in this since there is a proposal for a new Code section, which is what I will be discussing in the second part of the two part series.  Before finishing that piece, I thought I should read what the esteemed Laura Saunders of the Wall Street Journal had to say on the subject.  Her pieceCarried Interest in the Cross Hairs has me excited.  Apparently there is some thought that a recent tax court decision, a taxpayer victory, can be used to support regulations that would transform the capital gains treatment of carried interests into ordinary income.  She quotes former top Treasury officialMichael Graetz:

 

“This decision in Dagres v. Commissioner gives the Treasury Department a clear opportunity to write regulations raising taxes on carried interest.”

What excites me is that I have already written about that case.   I didn’t work up a full length post on it.  There were two other unrelated cases I discussed in the same post, but  I based the title “Having Your Cake and Eating it Too“  on the Dagres case.  Here is what I had to say:

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Todd A. Dagres, et ux. v. Commissioner, 136 T.C. No. 12

This one had a fairly interesting return presentation problem.  Mr. Dagres was a venture capitalist.  He loaned $5,000,000 to a business associate, who in addition to paying AFR would provide him leads on profitable investments. Apparently the business associate was not himself such a great investor as he was unable to pay the interest on the loan.  Ultimately it was settled with Mr. Dagres taking a loss of $3,635,218 on the transaction.  His position was that it was a business bad debt. The IRS said it was a non business bad debt, which would give rise to a capital loss.  Alternatively they argued that if it was a business bad debt it was related to his business of being an employee of a venture capital firm, which would subject it to the 2% floor and make it non deductible. [For purposes of AMT]  

Mr. Dagres, being a venture capitalist, had a pretty good salary $2,640,198. That is, of course, chump change compared to his capital gains of $40,579,41.  The capital gain was not mainly from his own investing.  It was the “profits interest” or “carry” from being a managing member of a venture capital partnership. 

I would have been scratching my head about the return presentation problem.  His advisers solved it by creating a Schedule C for his venture capitalbusiness and putting the bad debt deduction there.  Not elegant, but it worked.  

In exchange for this service, the fund managerreceives both service fees and a profits interest, but neither the contingent nature of that profits interest nor its treatment as capital gain makes it any less compensation for services.  

It looks to me like the Tax Court is letting the venture capitalists have their cake and eat it too.  The partnership gets investor treatment which is attributed to the manager, but the manager is allowed trade or business treatment for purposes of taking a deduction.

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I guess that shows you why I’m not a top treasury official or Professor of Tax Law at Columbia University, as Michael Graetz is now.  Professor Graetz sees an opportunity for the IRS to transform the tax treatment of an industry without the need for legislation from a Congress that let the estate tax lapse for a year.  I see “an interesting return presentation problem” (“An interestingreturn presentation problem?” – Well my old blog was called “Passive Activities and Other Oxymorons“)  Don’t be scornful.  The transactions connected with brilliant tax plans conceived by tax attorneys, who rarely prepare or even look at returns, need to be reflected on filed tax returns.  There is frequently a disconnect between the planners and the preparers particularly when it is the client doing the information transfer.

  I did, however, notice the inconsistency.  OK, Mr. Dagres, you are being allocated the partnership’s long term capital gain (the partnership being an investor), but when you see an ordinary loss opportunity, all of a sudden it’s business income.  Just for purposes of characterizing the deduction, mind you.  We used to have a saying at Joseph B. Cohan and Associates – “Pigs get fed.  Hogs get slaughtered”.  The same sentiment was expressed in the phrase – “Don’t be a khazzer !” Still the Tax Court bought it and the IRS is not going to appeal.

Looking back on the last 30 years of tax history I think Professor Graetz’s suggestion of turning a defeat in one area into a major victory in another is more typical of tax planners than the IRS.  The best example is the way the grantor trust rules, designed to prevent income shifting, gave birth to the “intentionally defective grantor trust”, which allows taxpayers to pay the income tax of their children and granchildren, without incurring a gift tax. (It can be really hard to get clients to understand how paying somebody else’s taxes is a good deal.)  What I’ll be watching for is an IRS pronouncement referred to as an Action on Decision.  They are not all that common.  There has been only one this year.  Less than 100 since 1967.   Basically the Service explains whether it is going to change any rules because of what the Court has told them.  Sometimes the AOD indicates that the Service doesn’t agree with the Court. Presumably, following Professor Graetz’s strategy, the AOD would say something like “In light of the Dagres decision, the Service will treat capital gain allocations from invesment partnerships to managers as trade or business income for all purposes.”  I don’t think it is very likely, but we’ll see.

After Note

If the Shakespeare reference in the title has you stumped, here is an explanation 

Lest you think I have carelessly confounded hedge fund managers and venture capitalists I assure you I am aware of the distinction.  I used hedge fund managers in the title because they are more in the news of late.  The “carried interest” concept works the same way for both groups.  It actually probably works better for venture capitalists since hedge funds produce a conglomeration of all sorts of different types of income and without distorting economic effects you shouldn’t be able to cherry pick different types of income to allocate to different partners without running afoul of the substantial economic effect rules.  It may be that someone, not currently incarcerated, has worked that out, but I’m not aware of it.  There is a sense in which hedge fund managers and venture capitalists are doing the same thing.  I think of hedge fund managers as venture capitalists with ADHD.