Obama and the Hedge Funds - With Enemies Like That, Who Needs Friends?

Originally Published on forbes.com on September 15th,2011

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I have compared President Obama’s battle with hedge funds toprofessional wrestling.  He was going to hit them with a chair –Proposed Code Section 710.  The hedge fund guys had a two by four to break the chair with – a Republican Congress that won’t raise taxes on anybody who doesn’t have to fly commercial.  Now we have theJobs Act where the Republicans will have to choose between the hedge fund Ayn Rand fans who have been doing such a great job running our economy or wounded warriors.  Congress  might break under that kind of pressure and pass the thing.

I was upset at Proposed Code Section 710, because, in principle, it applied to all partnerships.  What the partnership did was not relevant. The Section might apply to the one partner in an operating partnership who was primarily tasked with managingworking capital.  New Proposed Code Section 710 in the Jobs Act  fixes that.  An “investment services partnership interest”, by definition, has to be in an “investment partnership”.  It still does all the nasty things it used to do and it still applies to real estate held for rental which nobody seems to notice.  So it still looks like it will clobber the hedge fund guys and a couple of innocent bystanders, just not as many. It looks that way until you look at the definition of “investment partnership”:
(3) INVESTMENT PARTNERSHIP.—
(A) IN GENERAL.—The term ‘investment partnership’ means any partnership if, at the end of any calendar quarter ending after December 31, 2012—
(i) substantially all of the assets of the partnership are specified assets (determined without regard to any section 197 intangible within the meaning of section 197(d)), and
(ii) more than half of the contributed capital of the partnership is attributable to contributions of property by one or more persons in exchange for interests in the partnership which (in the hands of such persons) constitute property held for the production of income

 
Here is the definition of specified assets:
The term ‘specified asset’ means securities (as defined in section 475(c)(2) without regard to the last sentence thereof), real estate held for rental or investment, interests in partnerships, commodities (as defined in section 475(e)(2)), cash or cash equivalents, or options or derivative contracts with respect to any of the foregoing.

 
Is that an exhaustive list of what hedge funds invest in or will be investing in if they want to avoid the rule ?  I don’t think so.  What about working interest in oil and gas ?  How about land that is being actively farmed or a couple of hotels.  Maybe a gold mine.  How much in the way of non-specified assets will the hedge fund have to purchase to be out from under the “substantially all definition”.

 How much is “substantially all” ? In the context of qualifying as a home owners association 85% is substantially all.  In a reorganization context 90% of assets net of liabilities and 70% of gross assets could be “substantially all”.
Under the previously proposed legislation a partner who’s job it was topick stocks would have an “investment services interest” regardless of whatever else the partnership did.  Under this legislation, once the partnership acquires enough unspecified assets so that less than substantially all its assets are specified assets, it is not an “investment partnership” so nobody will have an “investment services interest”. 
I don’t know enough about the inner workings of hedge funds to know how hard this might be.  Would somebody running a billion dollars worth of stocks get somebody to go out and spend 200 million on a couple of hotels and some oil wells so that they could continue to get capital gains treatments on their carried interest ?  That could be like the tax tail wagging the economic dog.
I have two ways of looking at this.  One is the conspiracy theory.  Insiders deliberately snuck this change in so that the President can have the moral victory over the hedge funds without actually harming them. He has switched from professional wrestling to pillow fighting.  The other is how hard it is to fix what people perceive to be a special break for an industry when in reality it is just an application of general tax principles.  As I explained in my piece How Do Hedge Funds Work Their Tax Magic ?, the carried interest benefit is based on fundamental principles of partnership taxation.  The Jobs Act is able to take tax benefits away from the oil industry – percentage depletion and Section 199 deductions – because the oil industry is relatively easy to define.  Hedge funds are  more slippery than oil.   The original fix applied to all partnerships.  It could be that the new fix will not apply to very many.