Thursday, June 28, 2018

President Obama Could End Special Tax Treatment For Two Twenty Guys

This post was originally published on Forbes Sep 30, 2015

Deja vu  all over again.  Another presidential campaign.  Another flurry of concern about "carried interest".   The Cliff Notes version of "carried interest" is that people become partners in partnerships in exchange for future services and get some of their return in the form of capital gains, despite  never having contributed any capital. It seems that the practice is most resented when it benefits people running private equity funds - "hedge fund guys". Believe it or not, you can find a rationale for why this is good thing.

A rather intriguing group called Patriotic Millionaiers  explains why they think it is a bad thing.

And The Candidates

Some people find carried interest so upsetting that they will still be against carried interest even though other proposals they put forth will make it irrelevant.That's what Jill Stein and the Green Party did in 2012 proposing both treatment of capital gains the same as ordinary income and eliminating the "carried interest break".  Perhaps that was understandable as the Green Party 2012 platform was a kind of  big tent for a potpourri of left-wing notions. Oddly enough, it appears that Donald Trump makes the same mistake.  His proposal this week calls for the elimination of carried interest and a top business rate of 15% and a capital gains rate of 20%. In that environment converting ordinary business income to capital gains would be like turning gold into lead.

At least in the summary that Senior Policy Advisor Warren Gunnels  sent me, the Bernie Sanders campaign did not make the same mistake. Bernie wants to treat capital gain the same as other income and accordingly makes no mention of carried interest. Jeb Bush has come out in favor of eliminating carried interest in his plan.

Why Is This Carried Interest Thing Still A Thing?

What really has me going down the memory lane of the carried interest controversy is a recent article by Victor Fleischer - Two and Twenty Revisited: Taxing Carried Interest as Ordinary Income Through Executive Action Instead of Legislation. Professor Fleischer revisits an article published in 2006 - Two and Twenty: Taxing Partnership Profits in Private Equity Funds.  It appears that the discovery of Fleischer's 2006 article by Senate committee staffers is what made the tax benefits of "carried interest" a thing.
The part of the article that I found most intriguing is his explanation as to why nothing has been done about carried interest after all these years and significant disdain for the phenomenon coming from both left and right. It turns out that when I wrote pieces in 2011 and 2o12 with titles like - Obama vs Hedge Funds - Is it a Real Fight or Professional Wrestling? , there was social science behind my speculations on "carried interest" being a phony fight.  The field is called Public Choice Theory.
Carried interest presents itself as a perfect case study in public choice. The issue matters deeply to a small, well-organized, wealthy group of politically active individuals. The benefits of change, by  contrast, are diffuse. Politicians can simultaneously use the issue  effectively to extract rents from the one percent and then turn around and use the prospect of reform to energize the base. Whatever the merits of the issue, the positive prediction of public choice theory is clear: legislators will continue to talk about the issue, never quite acting on it, until its symbolic value has dissipated. 
Professor Fleischer took note of the issues that people like me - partnership tax geeks - have with the carried interest debate.
Many partnership tax experts view taxing carried interest as ordinary income is a departure from a basic principle of partnership tax. Subchapter K generally allows character to be determined at the partnership level, and it generally does not inquire into the nature of the contributions of different partners to the enterprise. In this sense it is similar to the tax subsidy for founders’ stock in the subchapter C context, and I am in the minority in finding the subsidy for founders’ stock to be bad tax policy.
I really did not like proposed Code Section 710 which I thought affected a lot more than private equity, where the perceived abuse was.  It turns out that in 2007, the broadening of the application of the fix was actually a way to create support for killing the legislation.
The Senate Finance Committee held a closed-door briefing  for the committee staff, staff from the Treasury and the I.R.S., and legislative assistants. The Senate Finance Committee passed legislation, dubbed the “Birthday Party” bill, that would have targeted publicly-traded private equity firms. Private equity lobbyists worked to quietly expand the target of the legislation to include smaller partnerships, real estate, venture capital, and oil and gas, all as an effort to gin up opposition to the legislation.
 The Solution

Professor Fleischer argues that the way to fix "carried interest" is by regulation not legislation.
President Obama should resolve the carried interest debate unilaterally by directing the Treasury Department to revise the regulations recently proposed under Section 707(a)(2)(A). The regulations  should provide that if a service partner contributes less capital to the partnership than the aggregate amount of capital contributed by taxexempt partners, any allocation of income to the service partner would be treated as compensation for services.
The case for executive action is both pragmatic and principled. Changing the tax treatment of carried interest could raise as much as $200 billion in revenue over ten years—enough to double the amount of federal dollars allocated to college financial aid, for example. Taxing fund managers at ordinary rates on their labor income would correct an injustice that exacerbates income inequality and allows an unnecessary tax subsidy to flow to the richest one percent of the one percent. Taxing carried interest as ordinary income advances efficiency, equity, and administrability. Doing so promptly through executive action would be legal, sensible, wise, and just
As a political analyst, I make a good tax preparer.  Nonetheless, I'm going to say that President Obama killing carried interest by regulation seems like great politics.  The attack on carried interest is one of the key populist pieces of both Bush and Trump's tax proposals.  Here is a chance for the President to pull the populist rug out from under them.
The regulation that Professor Fleischer proposes is drafted so that its effect would be fairly limited.  When I discussed the idea of using regulation back in 2011, there was concern by some experts that such an approach could create too much uncertainty.  James Whitmire one of the co-authors of McKee's Federal Taxation of Partnership and Partner, the premier treatise in the field wrote me:
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.
Professor Fleischer's approach is much more targeted and might not raise the same concerns.


I had a brief exchange with Professor Fleischer.  He thought it likely that funds would restructure to take advantage of the 15% rate if Trump's tax plan were enacted.  In an article in the New York Times in June Professor Fleischer wrote that the issue is worth about $18 billion a year.

Scott Greenberg of theTax Foundation in a piece earlier this month - The Carried Interest Debate is Mostly Overblown rates the issue as being worth $1.32 billion.  Professor Fleischer's much higher score has to do with carried interest recipients not being in the same position of actual holders of capital assets who can end up feeling locked in and avoid selling in the face of higher rates.

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