The taxation of carried interests in private equity

Virginia Law Review

Volumn 94, Issue 3, 2008, Pages 715-764

  Weisbach, David A ^a  

^a UNIVERSITY OF CHICAGO LAW SCHOOL   (United States)

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EID: 45949107002     PISSN: 00426601     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (105)

1. A carried or profits interest in a partnership is a right to a share of the profits separate from an interest in the assets or capital of the partnership. For example, if a partnership has $1,000 of capital and earns $100, a 15% carried interest would give the holder the right to 15% of the $100 profits and none of the $1,000 of capital. A capital interest gives the holder the right to both profits and capital. A 15% capital interest in the same partnership would be entitled to both 15% of the $100 profits and of the $1,000 capital. Carried interests and profits interests are effectively the same thing and I will use the terms interchangeably.
2. The two most prominent articles on the topic are Mark P. Gergen, Reforming Subchapter K: Compensating Service Partners, 48 Tax L. Rev. 69 (1992) [hereinafter Service Partners],
3. and Victor Fleischer, Two and Twenty: Taxing Partnership Profits in Private Equity Funds, 83 N.Y.U. L. Rev. (forthcoming 2008) [hereinafter Two and Twenty]. There have been four congressional hearings on the topic. See Carried Interest Part I: Hearing Before the S. Comm. on Finance, 110th Cong. (2007), available at http://www.senate.gov/~finance/sitepages/hearing071107.htm; Carried Interest Part II: Hearing Before the S. Comm. on Finance, 110th Cong. (2007), available at http://www.senate.gov/~finance/sitepages/hearing073107.htm; Carried Interest Part III: Pension Issues: Hearing Before the S. Comm. on Finance, 110th Cong. (2007), available at http://www.senate.gov/~finance/ sitepages/hearing090607.htm; Fair and Equitable Tax Policy for America's Working Families: Hearing Before the H. Comm. on Ways and Means, 110th Cong. (2007), available at http://waysandmeans.house.gov/hearings.asp?formmode= detail&hearing=584. Legislation has been introduced on a number of aspects of the issue including the Levin Bill, H.R. 2834, 110th Cong. (2007), and the Baucus-Grassley Bill, S. 1624, 110th Cong. (2007). For background information and descriptions of the bills, see Staff of Joint Comm. on Taxation, 110th Cong., Present Law and Analysis Relating to Tax Treatment of Partnership Carried Interests and Related Issues, Part I (JCX-62-07, Sept. 4, 2007) [hereinafter Partnership Carried Interests, Part I, Sept. 4]; Staff of the Joint Comm. on Taxation, 110th Cong., Present Law and Analysis Relating to the Tax Treatment of Partnership Carried Interests and Related Issues, Part II (JCX-63-07, Sept. 4, 2007).
4. There are many other, more fundamental problems with horizontal equity arguments. See Louis Kaplow, Horizontal Equity: Measures in Search of a Principle, 42 Nat'l Tax J. 139, 140-41, 148-50 (1989).
5. David A. Weisbach, An Efficiency Analysis of Line Drawing in the Tax Law, 29 J. Legal Stud. 71, 72-73 (2000) [hereinafter Weisbach, Efficiency Analysis];
6. David A. Weisbach, Line Drawing, Doctrine, and Efficiency in the Tax Law, 84 Cornell L. Rev. 1627, 1631 (1999) [hereinafter Weisbach, Line Drawing].
7. See The Blackstone Group, L.P., Securities Registration Statement (Form S-1), at 147 (June 11, 2007) [hereinafter Blackstone Offering]. For background on private equity,
8. see Jack S. Levin, Structuring Venture Capital, Private Equity, and Entrepreneurial Transactions (2006);
9. Andrew Metrick, Venture Capital and the Finance of Innovation (2007) [hereinafter Metrick, Venture Capital];
10. James M. Schell, Private Equity Funds: Business Structure and Operations (2007);
11. George W. Fenn, Nellie Liang & Steven Prowse, The Private Equity Market: An Overview, Fin. Markets, Institutions & Instruments, Nov. 1997, at 1;
12. Steven N. Kaplan & Antoinette Schoar, Private Equity Performance: Returns, Persistence, and Capital Flows, 60 J. Fin. 1791 (2005);
13. Ulf Axelson, Per Strömberg & Michael Weisbach, Why are Buyouts Levered? The Financial Structure of Private Equity Funds (January 4, 2007) (unpublished manuscript, available at http://ssra.com/abstract=676546);
14. Andrew Metrick & Ayako Yasuda, The Economics of Private Equity Funds (September 9, 2007) (preliminary draft, available at http://ssrn.com/abstract= 996334).
15. Blackstone Offering, supra note 5, at 148.
16. Id.
17. See Metrick, Venture Capital, supra note 5, at 7-9.
18. According to data from the Private Equity Council, in 2006 over 40% of investors were pension funds, and other tax-exempt investors made up 7.7% of investors. Funds of funds comprised almost 14% of investors. Taxable investors (other than funds of funds) included wealthy individuals (10.1%), banks and financial services companies (9.8%), insurance companies (7.5%), and family offices (6.8%). Together, taxable investors other than funds of funds made up about 38% of investors. Private Equity Council, Public Value: A Primer on Private Equity 11 Exhibit 6 (2007), available at http://www. privateequitycouncil.org/wordpress/wp-content/uploads/pec_primer_layout_final. pdf. See also Staff of the Joint Comm. on Taxation, 110th Cong., Present Law and Analysis Relating to Tax Treatment of Partnership Carried Interests 2, 37 (JCX-41-07, July 10, 2007) [hereinafter Partnership Carried Interests, July 10].
19. The 2% management fee and the transactions fees sometimes partially offset, so that transactions fees reduce (in part or in whole) the management fees.
20. See Metrick & Yasuda, The Economics of Private Equity Funds, supra note 5, at tbl. VI. See also Partnership Carried Interests, July 10, supra note 9, at 38 tbl.4 (citing Metrick and Yasuda). This figure initially strikes many as implausible, but it is easy to be blinded by the reports of very high returns that show up in the newspaper, and not notice the average or below market returns that do not. The Metrick and Yasuda study is an industry-wide study that looks at a large number of firms over more than a decade.
21. Private Equity Council, supra note 9, at 10. This feature differentiates typical private equity funds from typical hedge funds. Hedge funds often have a 20% carried interest calculated on an annual basis with no offsetting of gains in one year for losses in a future year. See René M. Stulz, Hedge Funds: Past, Present, and Future, 21 J. of Econ. Persp. 175, 178-79 (2007).
22. For example, if the stock was trading at $100 and the fund buys it at $150, it has to sell it at $200 to make a one-third profit on its investment.
23. See Kaplan & Schoar, supra note 5, at 1792-93, 1799.
24. Id. at 1801.
25. Partnership Carried Interests, July 10, supra note 9, at 39.
26. Axelson, Strömberg & Weisbach, supra note 5, at 3-4.
27. Options give the holder the upside of an investment without exposing them to the downside. As a result, options benefit from volatility. They get the benefit of the increased upside without the cost of the increased downside. If a holder of an option has managerial control that allows him to increase the volatility of the company, there is a risk that the holder will act contrary to the interests of the company. Pooling investments reduces the incentive to create volatility - the option element - because gains from excessive volatility with respect to one company are likely to be offset by losses from excessive volatility on another company.
28. See Paul Gompers & Josh Lerner, An Analysis of Compensation in the U.S. Venture Capital Partnership, 51 J. Fin. Econ. 3 (1999) (analyzing the value of profits interests for years including the late 1980s when there was no capital gains preference).
29. For example, a convertible bond can be thought of as a straight bond and an option to purchase stock. If the convertible bond does not trade at the right price compared to the straight bond and option combination, a hedge fund can sell one side and buy the other so that when they ultimately converge, the fund makes a profit.
30. For a description of these categories of investment, see Metrick, Venture Capital, supra note 5, at ch. 1.
31. A small sampling of articles includes Martin B. Cowan, Receipt of an Interest in Partnership Profits in Consideration for Services: The Diamond Case, 27 Tax. L. Rev. 161 (1971); Terence Floyd Cuff, Campbell v. Commissioner: Is There Now "Little or No Chance" of Taxation of a "Profits" Interest in a Partnership?, 69 Taxes 643 (1991);
32. Laura E. Cunningham, Taxing Partnership Interests Exchanged for Services, 47 Tax. L. Rev. 247 (1991);
33. Mark P. Gergen, Pooling or Exchange: The Taxation of Joint Ventures Between Labor and Capital, 44 Tax L. Rev. 519 (1989);
34. Barksdale Hortenstine & Thomas W. Ford, Jr., Receipt of a Partnership Interest for Services: A Controversy that Will Not Die, 65 Taxes 880 (1987);
35. Susan Kalinka, Rev. Proc. 2001-43 and the Transfer of a Nonvested Partnership Profits Interest, 79 Taxes 11 (2001);
36. Henry Ordower, Taxing Service Partners to Achieve Horizontal Equity, 46 Tax Law. 19 (1992);
37. Leo L. Schmolka, Taxing Partnership Interests Exchanged for Services: Let Diamond/Campbell Quietly Die, 47 Tax L. Rev. 287 (1991);
38. William R. Welke & Olga Loy, Compensating the Service Partner with Partnership Equity: Code Sec. 83 and Other Issues, 79 Taxes 94 (2001).
39. William S. McKee, William F. Nelson & Robert L. Whitmire, Federal Taxation of Partnerships and Partners ch. 5 (4th ed. 2007).
40. See Cuff, supra note 22, at 644 n.2.
41. The major court decisions include Diamond v. Comm'r, 56 T.C. 530 (1971), aff'd, 492 F.2d 286 (7th Cir. 1974), and Campbell v. Comm'r, 943 F.2d 815 (8th Cir. 1991). The Internal Revenue Service has also promulgated and proposed rules applicable to partnership profits interest. See Rev. Proc. 93-27, 1993-2 C.B. 343; Rev. Proc. 2001-43, 2001-2 C.B. 191; Prop. Treas. Reg. 1.83-3(1), 70 Fed. Reg. 29,675, 29,680 (proposed May 24, 2005) (to be codified at 26 C.F.R. pt. 1).
42. I.R.C. § 721 (2000). See McKee, supra note 23, for a detailed description of the partnership tax rules.
43. See sources cited supra note 22.
44. See sources cited supra note 22.
45. See Prop. Treas. Reg. § 1.83-3(1), 70 Fed. Reg. 29,675, 29,680-81 (May 24, 2005); Rev. Proc. 2001-43, 2001-2 C.B. 191; Rev. Proc. 93-27,1993-2 C.B. 343. All three take the position that taxpayers can value a profits interest at zero (in all but abusive situations) and, therefore, the receipt generates no tax.
46. 56 T.C. 530 (1971), aff'd 492 F.2d 286 (7th Cir. 1974).
47. 943 F.2d 815 (8th Cir. 1991).
48. Rev. Proc. 93-27, 1993-2 C.B. 343.
49. Rev. Proc. 2001-43, 2001-2 C.B. 191.
50. See Tax Section, N.Y. State Bar Ass'n, Report on the Taxation of Partnership Interests Received for Services and Compensatory Partnership Options 14 (2004).
51. Prop. Treas. Reg. § 1.83-3(1), 70 Fed. Reg. 29,675, 29,676 (May 24, 2005).
52. Id. at 29,680-81.
53. For a detailed explanation, see Chris William Sanchirico, The Tax Advantage to Paying Private Equity Fund Managers with Profit Shares: What Is It? Why Is It Bad?, 75 U. Chi. L. Rev. (forthcoming 2008) (manuscript at 12-24, on file with the Virginia Law Review Association), available at http://ssrn.com/abstract=996665.
54. Partnership Carried Interests, Part I, Sept. 4, supra note 2, at 19-20.
55. I.R.C. § 707(a)(2)(A) (2000).
56. Staff of Joint Comm. on Taxation, 98th Cong., General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, at 227-29 (Comm. Print 1984).
57. Id.
58. Id.
59. Id.
60. See Sanchirico, supra note 37, at 15, for a detailed discussion of the issue.
61. They are likely guaranteed payments for services under § 707(c) rather than payments to a nonpartner under § 707(a)(2)(A). For our purposes, the two are essentially the same.
62. See, e.g., Lee A. Sheppard, Blackstone Proves Carried Interests Can Be Valued, 115 Tax Notes 1236, 1238 (2007).
63. See sources cited supra note 22.
64. See Sheppard, supra note 46, at 1238.
65. See discussion infra Part IV.
66. Following this logic, Professor Cunningham would distinguish profits interests received for services performed in the past from those received for services to be performed in the future. Cunningham, supra note 22, at 260. For services performed in the past, none of the problems discussed in the text exist. Instead, it looks like the service provider has received a risky security in exchange for having performed services. Bittker and Lokken, in their tax treatise, make the same argument. See Boris Bittker & Lawrence Lokken, 4 Federal Taxation of Income, Estates, and Gifts ¶ 86.2.4, at 86-22 (3d ed. 1999).
67. Service Partners, supra note 2, at 103-11. See also Two and Twenty, supra note 2, at 47.
68. Service Partners, supra note 2, at 94.
69. For example, § 67 may limit the deduction in some cases.
70. Service Partners, supra note 2, at 106-07 (giving examples of how a pro rata measure would understate service income).
71. H.R. 2834, 110th Cong. (2007).
72. The Levin bill also differs from the Gergen proposal in that it would merely recharacterize the payment to a profits partner as ordinary income while the Gergen proposal would create offsetting income and deductions similar to those created by § 707(a)(2)(A). This creates a tax difference if the deduction to the partnership under the Gergen proposal is capitalized or otherwise deferred or disallowed, with the Levin bill being more generous to the partnership than the Gergen proposal in these cases.
73. Schmolka, supra note 22, at 302-08; Noël B. Cunningham & Mitchell L. Engler, The Carried Interest Controversy: Let's Not Get Carried Away, 11-15 (Sept. 4, 2007), http://ssrn.com/abstract=1014974. Schmolka himself would prefer to do nothing and offers his implicit loan proposal only as a secondary option if something must be done. Schmolka, supra note 22, at 312.
74. The applicable federal rate is described in I.R.C. § 1274(d) (2000). It is, effectively, the Treasury rate for a loan of equivalent maturity.
75. If the investment does not return 8%, the limited partners will not get paid their full return, but this is the same as with any nonrecourse loan.
76. See I.R.C. § 1274 (2000); I.R.C. § 7872 (2000).
77. See Kaplow, supra note 3; Peter Westen, The Empty Idea of Equality, 95 Harv. L. Rev. 537 (1982).
78. Sanchirico, supra note 37, at 66.
79. For a detailed discussion of analogical reasoning, see Edward H. Levi, An Introduction to Legal Reasoning (1949).
80. Fair and Equitable Tax Policy for America's Working Families: Hearing Before the H. Comm. On Ways and Means, 110th Cong. n.2 (2007) (statement of Mark P. Gergen, Professor of Law, The University of Texas School of Law, Austin, Texas), available at http://waysandmeans.house.gov/hearings.asp?formmode= view&id=6433.
81. The arguments relating to the unsoundness of the investment analogy made by the Joint Committee on Taxation in its September 4, 2007, report on carried interests suffer from the same problems. The Joint Committee makes four arguments. First, it argues that it is not appropriate to treat the capital in the investment fund as owned entirely by the fund manager. Second, the Joint Committee argues that treating the limited partnership as a capital raising device is "inconsistent with the idea that the fund manager has only a partnership profits interest." Third, the Joint Committee argues that it is inconsistent with the pass-through tax treatment to investors. Finally, the Joint Committee questions whether the interests could be characterized as debt. At the core of all of the Joint Committee's arguments is an adherence to the debt/equity distinction - financing comes in the form of debt, not in the form of equity. The Joint Committee, however, does not provide any arguments on why the treatment of the carried interest should depend on whether it obtains financing in the form of debt or equity. Partnership Carried Interests, Part I, Sept. 4, supra note 2, at 55-56.
82. Compare Comm'r v. José Ferrer, 304 F.2d 125 (2d Cir. 1962), with United States v. Dresser Indus., 324 F.2d 56 (5th Cir. 1963).
83. See The Taxation of Carried Interest: Hearing Before the S. Comm. on Finance, 110th Cong. 1 (July 11, 2007) (statement of Peter R. Orszag, Director, Congressional Budget Office).
84. Note that under this approach, we might not change the treatment of private equity at all. Under current structures, approximately two thirds of the returns to private equity sponsors are taxed as ordinary income. This may very well represent a reasonable allocation between the labor and investment elements and, therefore, a reasonable tax treatment.
85. Schmolka, supra note 22, at 302-08.
86. Two factors appear to be essential in determining when returns to labor get capital gains treatment. First, the more entrepreneurial the activity, the more likely the treatment will be capital. Second, the more that labor and capital are combined into a single return, the more likely it will be treated as capital. Consider some well-established cases. Everyday salaries that represent arm's length compensation for ordinary, non-entrepreneurial work are taxed as ordinary income. Employee stock compensation, pay for performance, and nonqualified options have a closer connection to entrepreneurial activity in that they expose the employee to the risk associated with the success of the enterprise. These amounts are generally treated as ordinary income when they vest, subject to certain exceptions such as a § 83(b) election. Additional amounts are taxed as capital gains. On the other hand, self-created assets, including, significantly, patents under § 1235, get capital gains treatment. An inventor who puts in many hours of labor gets capital gains treatment when the invention is sold. A proprietor who raises capital to start a business and uses his expertise and labor to build the business receives capital gains when he sells the business. Similarly, founders of companies get capital gains treatment when they sell their shares, even if the gains are attributable to labor income. For example, most, if not all, of Bill Gates's fortune comes from his performing services for Microsoft, but the overwhelming majority of his earnings from Microsoft will be taxed as capital gains. He engaged in entrepreneurial activity that combined labor and capital.
87. See Weisbach, Efficiency Analysis, supra note 4; Weisbach, Line Drawing, supra note 4.
88. In a short-against-the-box transaction, a taxpayer who owns stock borrows identical stock and sells it short, using the original shares as collateral for the short sale. The transaction completely eliminates the risk of gain or loss on the stock or from variable dividends with respect to the stock, and allows the taxpayer to withdraw substantially all of the cash invested.
89. See I.R.C. § 1259 (2000) (treating a short-against-the-box and similar transactions as sales).
90. Joel Slemrod & Shlomo Yitzhaki, The Costs of Taxation and the Marginal Efficiency Cost of Funds, 43 Int'l Monetary Fund Staff Papers 172, 186-89 (1996).
91. There is some limited evidence that the revenue that might be raised would not be significant. See Michael S. Knoll, The Taxation of Private Equity Carried Interests: Estimating the Revenue Effects of Taxing Profit Interests as Ordinary Income 7-14 (U. Pa. Law Sch. Inst. for Law & Econ., Research Paper No. 07-20, 2007), available at http://ssrn.com/abstract=1007774.
92. Am. Law Inst., Federal Income Tax Project, Subchapter K, at 5 (1984).
93. See Lloyd v. Comm'r, 15 B.T.A. 82, 86-87 (1929); Bittker & Lokken, supra note 50, ¶ 89.1.1.
94. I.R.C. § 707(c) (2000).
95. Pratt v. Comm'r, 64 T.C. 203 (1975).
96. Even in this case, we know that some portion - perhaps a substantial portion - is capital income in the sense that it represents returns that are left in the business rather than taken out each year as salary. Nevertheless, we might sensibly say that the best compromise is to treat it all as labor income exactly as we do in the case of restricted stock or nonqualified options.
97. The salaries could be below market, and some portion of the returns could be service income equally to A and B. In the text, I am trying to see whether we can identify a profits interest - an allocation to one of the partners as a payment for services. The problem of undercompensation arises even with straight-up allocations.
98. I.R.C. § 704(b) (2000).
99. As the Joint Committee noted, the carried interest got nothing in 30% of private equity transactions during the period they studied. Partnership Carried Interests, Part I, Sept. 4, supra note 2, at 23.
100. One potential tax difference is that the interest on the loan from the limited partners would be investment interest subject to the limitations under § 163(d). Either the general partners would have to have that much investment income otherwise in their portfolios or the private equity fund could ensure that the portfolio companies pay dividends sufficient to cover this amount. An economic difference is that if the fund does not earn at least 8%, the general partners would owe the limited partners the interest on the loan without receiving an offsetting distribution from the partnership. This risk could be mitigated by using a different allocation scheme, where the general partners receive their first 1% earlier.
101. Howard E. Abrams, Taxation of Carried Interests, 116 Tax Notes 183, 186 (2007). An advantage of this structure over the one described above is that it avoids problems created by § 163(d).
102. Professor Michael Knoll argues that this structure would not be respected because it implicitly relies on a below-market interest rate on the loan from the limited partners. Knoll, supra note 75, at 14-15. It will, however, be difficult for the government to challenge the interest rate on audit. The government would have to rely on § 482, which is rarely successful. Moreover, if this simple structure with a direct loan between partners can be challenged, the loan can be made through third-party financial intermediaries, similar to the transactions described in Rev. Rul. 87-89, 1987-2 C.B. 195.
103. Knoll, supra note 75, at 16-18.
104. For example, Victor Fleischer entices the reader with terms like "airplane rich" (meaning you can afford your own airplane). Fleischer, supra note 2, at 20 n.73.
105. Gates and private equity sponsors will equally be subject to the estate tax.