Can Obama End "Carried Interest" by Regulation? - Experts Start Weighing In

Originally Published on forbes.com on September 3rd,2011

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I have speculated that President Obama is engaged in a phony war with hedge fund managers.  Rather than tackle the “carried interest” problem (assuming it is a problem) by regulation, he has submitted proposed legislation that would add 3,000 words to the Internal Revenue Code and affect taxpayers besides hedge fund managers.  Thanks to a Republican Congress that has pledged to not raise taxes on anyone who can afford to vacation in Tahiti, the hedge fund managers would be more scared if he were using his Red Ryder BB Gun. I have been casting about for expert opinion on my speculation and have received a couple of answers.

Why am I writing about this if I am not an expert ?

“Carried interest” is not a technical tax term.  The technical tax term is “profits interest”.  The term comes from partnership taxation, which is how the advisers of hedge fund managers work the magic of turning service income into capital gains.  Most of the commentary on the issue outside of technical tax publications would not teach you that.  To be an expert in partnership taxation you need a law degree and an advanced degree in taxation. I’m a mere CPA who has been overseeing the preparation of partnership tax returns for 30 years.  My role is to bridge the gap between the documents drafted by theexperts and the tax returns.  Sometimes, not often, the clients have questions about the returns beyond showing them where to sign.  Then I have to show them the clause in the partnership agreement that determines that even though they think they are a 30% partner they are not getting 30% of the losses.  I sometimes beg them to include the attorney who drafted the documents in the discussion, but often to no avail.

My first expert

Michael Oleske

In a previous post, I made an analogy between partnership taxation and a religion.  In that religion, I would be an altar boy, a senior altar boy, one of the eighth graders who could sleep late on Sunday, because he had the 12 O’clock Mass.  I’d like to try another analogy, here.  If partnership taxation were an army, I would be a first sergeant.  I hope that we will be hearing from a general later on, but we are starting off with a lieutenant, my good friend Michael Oleske.  Mike has the right education.  I have not assigned him a very high rank in the partnership taxation army though, because he has spent his career working as in-house tax counsel forinsurance companies.  That makes him more of a Subchapter L man than a Subchapter K man, but he is still worth hearing from:

I do have a substantive comment on your question about whether a reg would do the trick to fix the “carried interest” issue.  [Since I have an LLM in tax, I understand that I have permission to speak.]  Clearly a reg could be issued that characterizes all income earned by fund managers as ordinary rather than capital gain.  But I think that the problem is that this type of reg, not being grounded in any particular legislative history that tells the Treasury to do this, would be subject to challenge, even in a post-Mayo environment.   So, any change would probably need to be by legislation if we are looking for a definitive change.  Of course, we don’t need the absurd approach taken in HR 2495. 

Will Congress actually do it?   The government is so dysfunctional that all bets are off.   We need a complete overhaul of the Code and no one wants to do any lifting at all, never mind the heavy lifting that real tax reform would entail.  I think the Republicans appointed to the super committee all had to agree to have their eyes glued open with Krazy Glue so that no one blinks when the question of tax increases is put on the table by the Democrats.

 Mike commented on how the issue might be addressed by regulation:

I think that the classic partnership is between a person with talent (who will do all the work) and someone with money.  Every example in law school of a partnership follows this basic design.  So, I’m not so sure that Subchapter K isn’t built on the same premise that there will always be investor partners and working partners.  The tax law lets them both get capital gains on the appreciation of investments in the partnership.  As long as the service partner isn’t getting guaranteed payments, he’s treated the same as any other partner.

To come up with a different approach to taxing these arrangements, you would have to say that the service partner-investor partner arrangement is not a partnership for tax purposes but a form of service agreement with contingent payments to the service provider.

 Essentially that is my suggestion.  Adding the arrangement to the list of examples in Reg 1.701-2 of things that Subchapter K was not meant for.  I hate to spoil the surprise but the top experts really don’t like that idea.  Stay tuned.

Memory Lane – Me and Mike

Mike has been very kind to me over the last 30 years.  I call him occasionally with arcane questions, which need a tax attorney perspective but I would be too embarrassed to ask someone I might be working with in the future.  We go way back.  We became friends  in high school.   We both loved to listen to Jean Shepherd.  The choice of the military analogy is particularly apt in this case, because the student body of Xavier High School was organized as a regiment of the Junior Reserve Officers Training Corps of  the United States Army.   About 1/3 of the seniors were officers, 1/3 were higher sergeants, the rest – well it was quite an achievement to graduate from Xavier as a private, very thin line between never getting promoted and getting thrown out.  Mike was a cadet lieutenant and I was a first sergeant.  Lest you think that remembering your cadet rank is a sign that you are a loser, no less a figure than Antonin Scalia, class of 1953, in a recent speech to the regiment, bragged about having been a lieutenant colonel.  I don’t think you can infer a strong correlation between cadet rank and later success in life from three data points, but it is what it is.

My memories of Xavier are very fond.  There are two faculty members I particularly remember.  One was Major Smullins, the Senior Army Instructor.  Major Smullins was assigned to be the SAI at a high school a few blocks north of Greenwich Village that was run by a religious order,  the Jesuits, whose then most famous member, Daniel Berrigan, was in prison for destroying draft records.  I doubt that the SAI job was more stressful than whatever he had been doing in Vietnam, but I wouldn’t be shocked if it was.  Major Smullins didn’t make me a cadet officer and flunked me in military science and his “block of instruction” on the Psychology of Leadership was the best management training I ever received.  Sorry for the lack of fact checking capability, but I believe his first name was Francis – as far as I was concerned back then his first name was Major.  A classmate, who became a real Army officer told me he retired as a full colonel. So I hope Francis Smullins, Col. USA (Ret.) is doing well and will still take my salute.

The other is Mr. Brian Moroney.  Mike and I had him for English  sophomore and senior year.  He spent his career at Xavier retiring in 2007.  To the extent my writing is any good, it is largely thanks to Mr. Moroney.  To the extent it sucks, it is in spite of him.  If you can read this, you should thank a teacher.  If you like it, you should thank Mr. Moroney.