Ending Carried Interest by Regulation - View From the Very Top

Originally Published on forbes.com on September 12th,2011

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“Carried Interest” is the industry term for the method that allows hedge fund and venture capital managers to receive much of the income they earn in the form of capital gains.  What does not appear to be widely understood is that “carried interest” is not, itself, a tax concept.  The related tax concept is “profits interest”.  The benefit that hedge fund and vc managers get from having a profits interest is not some special break designed for their industries.  The benefit comes from the application of fundamental principles of partnership taxation.  The fix proposed for the perceivedproblem (Proposed Code Section 710) adds three thousand words to the Internal Revenue Code and an entirely new concept “investment services interest”.  It affects partnerships other than hedge funds and vc partnerships.

I have maintained that the Obama administration’s war on hedge funds is phony.  The President appeases his left wing base by introducing bad legislation that is not narrowly targeted on the perceived abuse.  Not to worry, though, the Republican Congress will not raise taxes on anybody who can afford a Lexus.  Is there a wink and a nod to the hedge fund guys in there somewhere ?  What if the problem, assuming it is a problem, could be fixed by adding a paragraph to the regulations or as Professor Michael Graetz has suggested just following the logic of the Tax Court which allowed an ordinary deduction for a bad loan made by Todd A. Dagres, who had $40,000,000 in capital gains from a carried interest?  Then the administration would be responsible.

I haven’t had any luck reaching Professor Graetz for comment on his propostion but I did get Charley Egerton, former chair of the American Bar Association Tax Section, to comment on how bad Proposed Code Section 710 was.  My friend Michael Oleske also has a low opionion of 710.  Whenever I call Charley with a question the first thing he says is “Did you check McKee?”.  He is referring to McKee, Nelson & Whitmire, Federal Taxation of Partnerships and Partners .  Emboldened by my new association with Forbes, I tried the authors of whom there are now five.  James Whitmire of Davis, Graham & Stubbs responded.  He is not the Whitmire in the standard citation for the book.  That is Robert Whitmire of Terra Partners LLC.  The correspondence of surname is not coincidental.  James Whitmire is a second generation partnership tax expert of the highest level.  Truly amazing.  You would be surprised how few young people are enthralled by discussions of minimum gain, capital account maintenance rules and substantial economic effect.  When I bring those topics up with my 18 year old son we usually quickly switch to topics of more common interest like why he prefers Orc avatars and I lean towards the humans in World of Warcraft.

My suggestion was that a paragraph be added to the partnership anti-abuse regulations to the effect that organizing the co-ownership of invesmtents as a partnership so that the incentive compensation of the investment advisers would be in the form of a share of a capital gain allocation was inconsistent with the purposes of Subchapter K.  Here is what Mr. Whitmire has to say to that:

I think that interpreting 1.701-2 in that fashion would lead to more damage to other partnerships than proposed Section 710 would. 1.701-2, when enacted, created tremendous concern from the tax community that it gave too much discretion to the IRS in pursuing transactions that it viewed as abusive. In the 15+ years that have followed, practitioners have, more or less, gotten comfortable that that IRS discretion will not be abused. If the IRS now uses that discretion to aggressively interpret the anti-abuse rule in the manner you propose, we’d be back in a world of fear, severely impeding any practitioner’s ability to give comfort on a partnership transaction.  Most practitioners I know would rather deal with the certainty of something approaching a bright line rule created by proposed 710, than a world of confusion created by a broad interpretation of 1.701-2.

This is consistent with the commentary in Federal Taxation of Partnerships and Partners:

Regulations § 1.701-2 was proposed in 1994, and then finalized in 1995 over the protests of most practitioners, including the authors.

It happens that I was on the AICPA Tax Division Partnership Committee when the regulations came out.  It was probably coincidental that the regulations were released when the Tax Division was having one of its meetings (Boy those meetings were exciting. Rumours about the existence of flocks of tax groupies showing up when the tax superstars gather in conclave are greatly exaggerated, though).  The other partnership folks at the meeting were real excited about the regulations.  I saw that the affordable housing deals I worked on were an example of “good partnerships” and didn’t think about it any further. Tax planners want predictability so that they can  draft documents whose tax effects will be known in advance at least under current law.  In a follow-up I asked Mr. Whitmire who he meant by “practitioners”:

I’m referring to the deal designers and document drafters. I don’t know that we’re the high priesthood, but we’re certainly the ones who agonize the most over the risks associated with what we’re designing. I’ve found that the skill level of the tax preparer varies dramatically and it’s critical to find appropriate partners to whom I can refer my clients and ensure that they’ll understand the structure – both to protect the structure and to minimize client cost and confusion.

I appreciate his recognition of the role that my crowd plays in making good tax plans work.  One of my themes is how good plans are ruined by poor execution.  I do understand Mr. Whitmire’s distaste for using the regulations to end “carried interests” for hedge fund managers. Charely Egerton has a similar view.  Congress is supposed to make laws and, in a free country, taxpayers should be able to arrange their affairs to follow the laws without fear of someone second guessing their motives.  As Learned Hand wrote:

Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.

 Charley Egerton has gone so far as to use his bully pulpit to ask Congress to devastate the membership of his ABA Tax Section:

The goal that Congress ought to have is to put as many of us out of business as possible.  Now I say that with full confidence that it’s not going to happen.

The ABA Tax Section did have a 22% membership drop after the passage of the Tax Reform Act of 1986.  But after simplifying Congress was soon back to complifying (That’s a neologism, not a typo).  I believe that there are fundamental reasons why this happens.  People whose job it is to make laws are going to respond to their constituents by making more laws.  If we really want tax simplification to stick Congress needs to make the Internal Revenue Code of 2013 very short containing only broad principles.  Then regulations need to be written by policy wonks (maybe some of the attorneys who become unemployable) who are insulated from the political process.  They should include some CPAs so the regulations will have instructions on what to debit and what to credit.  They should probably get some former national firm guys who are now making desks for Unicor to explain how they would  game the regulations before they are released. You don’t have to pay them much.  At least according to this source, the maximum is $1.15 per hour.

Conclusion:
I still think the administration’s attack on hedge funds is phony.  The real experts have some good reasons why attacking carried interest by regulation would be a bad idea, but I doubt that those reasons are what is influencing the administration.  In the event that Code Section 710 ever did pass, it would, for me, be both a nightmare and a dream come true.  All the carefully crafted existing deals would all of a sudden have a new concept that might or might not apply to them.  On existing deals, the first people confronting the law change are the preparers not the planners.  So it is a nightmare, because it is a lot of work.  And it is a dream come true, because it is a lot of work.  Depends on which side of the bed I get up on in the morning.