Obama vs Hedge Funds - Is it a Real Fight or Professional Wrestling ?

Originally Published on forbes.com on September 1st,2011

______________________________________ 

President Obama jumps into the ring with a chair – a proposed Code Section – and hurls it at the hedge fund managers.  They are prepared.  They swing a two by four – a Republican controlled Congress that has pledged to not raise taxes on anybody who can afford a Lexus.  Great drama.  The President has fought the good fight and lost this time, but he will be back.

Is it  all a show?  Maybe  carried interest, the magic that turns investmentservice income into capital gain, is not an impervious brick house, but a house of straw, that could be blown down with a single breath – a paragraph in the Code of Federal Regulations, that does not require Congressional approval.

One of the most troubling things my father ever told me was that professional wrestling wasn’t real.  I was told later in life that he never said that around his mother, to me Nanna Reilly, who was a passionate fan of TV professional wrestling.  At any rate when I think of President Obama and his attack on hedge fund carried interests I wonder if I am watching professional wrestling being staged for the benefit of the left wing of the Democratic party.  In order to explain the basis of this theory I have to bring you into the weeds of partnership taxation where I now spend a lot of my time.

What is so special about the tax rules for hedge fund managers ? Nothing.

 Everybody knows that “carried interest” is the way that hedge fund managers magically transform their service income into capital gains.  What does not seem to be widely understood is that “carried interest” is not some sort of special provision that somebody slipped into a defense bill or something.  It is based on fundamental principles of partnership taxation.  The fundamental principles are that the nature of a transaction is determined at the partnership level and the partner is deemed to stand in the shoes of the partnership.  That means that if the partnership is a trader in securities then a partner is treated as a trader in securities with respect to her allocable share of the partnership’s income and expenses.  If the partnership is an investor then all the partners including service partners with profits interests are treated as investors with respect to their allocable shares.  Those rules are for everybody, not just hedge fund managers and venture capitalists.

Is the cure worse than the disease ?

Now I cannot say that I am a partnership expert.  I don’t have a law degree oreven a masters in taxation (My masters is in applied mathematics).  Nonetheless, I am qualified to say that the proposed legislation – Proposed Code Section 710 - is a nightmare for businesses besides hedge funds andventure capital.  Most particularly it affects real estate, which doesn’t ever seem to come up in the discussion.  Here is the worst part.  There is no grandfather provision.

Partnership taxation works like this.  An entrepeneur comes up with an idea for a business.  He consults with an attorney and a CPA about the best vehicle.  Often it is an entity that is considered a partnership for tax purposes (That includes most LLC’s for example).  A plan is devised and appropriate documents are drafted by attorneys.  The documents have provisions that will produce the expected tax results.  There are transactions that the entrepreneur’s internal accounting department record, usually with a view towards providing good operating information and financial statement information – the tax details of the plan, maybe not so much.  The year ends and they ship the numbers to a tax preparer.  On your larger deals, that will frequently be a CPA.  The CPA is supposed to take the numbers and the agreements and fit them together into a return that is consistent with both and prepare the return.  That is kind of the end of the line.  A problem crops up sometimes because the attorneys were finished when the agreements were done.  Assuming it is a deal that starts on January 1st and that the return is extended it might be nearly two years from the time the agreement is drafted till the first return is prepared.  Many of the provisions of the agreement will only be relevant much later in the life of the partnership.  The time between drafting  and being translated into a return for those provisions could be more than a decade. 

There is no grandfather provision in Code Section 710 so it will affect existing deals.  It adds 3,000 words to the Internal Revenue Code.  It’s implementation with respect to existing deals will not be in the hands of attorneys who study the Code and draft documents.  It will be in the hands of CPA’s who frankly often have difficulty interpreting the existing deals.  I am fond of historical analogies.  The are often incomprehensible to anybody else, but I use them anyway.  For purposes of this analogy I need you to put aside who you think the good guys and bad guys were during WW II.  Proposed Section 710 is Germany.  Hedge fund managers and venture capitalists are France.  Other partnerships where partners have profits interests and tax preparers are Belgium.

Are Profits Interest a Bad Thing ?

“Carried interest” is an industry term, not a tax term.  The tax term is “profits interests”.   Someone receives an interest in a partnership  not from contributing money or property, but because he is going to work there. How does something qualify as a “profits interest”?  You do a hypothetical liquidation on the day the interest is issued.  If the person who received the interest would get nothing in that hypothetical liquidation, then it is a profits interest.  Otherwise the receipt of the partnership interest would be a taxable event.  Why is this a good thing ?  It allows someone with an idea to team up with someone with money.  The idea guy only gets a piece of the upside.  The money guy usually gets his money back, often with a preferred return, first.  It is very much like qualified stock options

What is wrong with hedge fund managers getting profits interests?

Personally I’m not that much bothered by it, but it seems like the idea is that they are more like mutual fund managers than entrepreneurs starting businesses.  They are not building up businesses.  They are picking winners.

Do we need to add three thousand words to the Code to fix this ?

Assuming,  for the sake of argument, that there is something that needs fixing it could be fixed by adding a paragraph to the regulations.  Essentially it would say that things like hedge funds are in essence co-ownerships with advisers and that partnership rules should not apply to them.  Michael Graetz , who as a professor at Columbia University has the right credentials, thinks that a recent decision by the Tax Court would allow the IRS to take the position that they could tax venture capital profits interests as ordinary income as the law stands now without even changing the regulations.

To use another analogy are carried interest for hedge fund managers Iraq or Libya ? Do we need ground troops – a change in the Internal Revenue Code? Can it be done with surgical air strikes ? – tweaking the regulations.  If the latter, why doesn’t the administration just do it ?

The cynical view.

President Obama gets money from the hedge fund guys.  President Obama has to do something to appease his left wing base.  So he does something.  He calls for legislation that won’t be passed.  Is there a wink and a nod to the hedge fund guys in there somewhere ?

More on this later ?

I have asked some real partnership experts about whether a tweak in the regulations could fix the problem.  So far I have gotten one response from the very top of the intellectual hierarchy of partnership taxation.  I’m not optimistic that I will get more, but hope springs eternal. In the mean time, if you want to talk about carried interests and you don’t know anything about partnership taxation and don’t want to learn, just shut up.

About Comments

You may be reading this on a site other than forbes.com.  Comment away, but if you will also then log on to forbes.com, more people will see your comment and I will be able to respond.