The tax advantage to paying private equity fund managers with profit shares: What is it? Why is it bad?

University of Chicago Law Review

Volumn 75, Issue 3, 2008, Pages 1071-1153

  Sanchirico, Chris William ^a,b  

^a Department of Law Business and Public Policy ^*

^b UNIVERSITY OF PENNSYLVANIA   (United States)

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EID: 57049173408     PISSN: 00419494     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (264)

1. See generally Department of the Treasury, A Report to Congress in Accordance with § 356(c) of the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (USA Patriot Act) ("Treasury Report") 26-29 (Dec 31, 2002), online at http://www.fincen.gov/356report.pdf (visited June 8, 2008) (describing the key elements and parties involved in private equity funds);
2. SEC Staff Report, Implications of the Growth of Hedge Funds ("SEC Report") 7-8 (Sept 29, 2003), online at http://www.sec.gov/ news/studies/hedgefunds0903.pdf (visited June 8, 2008) (describing the setup, operation, and dissolution of private equity funds);
3. Andrew Metrick and Ayako Yasuda, The Economics of Private Equity Funds 5-14 (Swedish Institute for Financial Research Conference on the Economics of the Private Equity Market, Sept 2007), online at http://ssrn.com/abstract=9%334 (visited June 8, 2008) (describing the economics of private equity and venture capital funds with frequent reference to and analysis of a novel database);
4. Henry Ordower, Demystifying Hedge Funds: A Design Primer, 7 UC Davis Bus L J 323, 329 (2007) (describing the law governing various investment funds including regulated investment companies, private equity funds, venture capital funds, hedge funds, and real estate investment trusts).
5. See also Emily Thornton, What's Bigger than Cisco, Coke, or McDonald's? Steve Feinberg's Cerberus, a Vast Hedge Fund That's Snapping up Companies - Lots of Them, Bus Wk 100, 100-10 (Oct 3, 2005) (profiling a prominent private equity fund manager).
6. Stephen Taub, The Top 25 Moneymakers: The New Tycoons, Alpha Magazine (Apr 24, 2007), online at http://www.alphamagazine.com/Article.aspx? ArticleID=1328498 (subscription only) (visited June 8, 2008) (profiling the twenty-five highest earning private equity and hedge fund managers).
7. Jenny Anderson and Julie Creswell, Make Less than $240 Million? You're Off Top Hedge Fund List, NY Times Al (Apr 24, 2007) ("With the modern gilded age in full swing, hedge fund managers and their private equity counterparts are comfortably seated atop one of the most astounding piles of wealth in American history.").
8. A LexisNexis search of major newspapers reveals hundreds of articles and editorials published over the last year on the issue of carried interest alone. Several of the most informative of these are cited in this Article. See notes 1-3, 7, 18, 21, and 199. Editorials by major newspapers include: Editorial, Taxing Private Equity, NY Times A22 (Apr 2, 2007) ("Today's preferential rate for capital gains is excessive . . . . Tackling the too-easy tax terms for private equity is a good way for Congress to begin addressing that bigger issue.");
9. Editorial, Assault on the Investor Class, Wall St J A14 (May 7, 2007) ("There's no good rationale for [taxing carried interest as ordinary income] beyond the fact that Congress wants money and private equity funds have lots of it.");
10. Editorial, The Wrong Loophole; Senators Looking to Restore Tax Cuts Should Keep Their Hands Off Private Equity Funds' Capital Gains, LA Times A14 (May 15, 2007) ("This time law-makers are barking up the wrong loophole.").
11. In the Senate, the Finance Committee held a well attended three-part hearing over the summer of 2007 on the tax treatment of the earnings of private equity fund managers. Carried Interest Part I, Hearings before the Senate Committee on Finance ("Carried Interest Part I Hearings"), 110th Cong, 1st Sess (July 11. 2007), online at http://www.senate.gov/~finance/ sitepages/hearing071107.htm (visited June 8, 2008); Carried Interest Part II, Hearings before the Senate Committee on Finance ("Carried Interest Part II Hearings"), 110th Cong, 1st Sess (July 31, 2007), online at http://www.senate.gov/~finance/sitepages/hearing073107.htm (visited June 8, 2008); Carried Interest Part III: Pension Issues, Hearings before the Senate Committee on Finance ("Carried Interest Part III Hearings"), 110th Cong, 1st Sess (Sept 6, 2007). online at http://www.senate.gov/~finance/ sitepages/hearing090607.htm (visited June 8, 2008). Senators Baucus and Grassley, the Chair and ranking minority member, respectively, of the Finance Committee have cosponsored, along with others, a bill to impose corporate level tax on publicly traded private equity partnerships. S 1624, 110th Cong, 1st Sess (June 14, 2007), in 153 Cong Rec S 7733-01 (June 14, 2007). In September 2007, the House Ways and Means Committee held a hearing to consider, among other things, a measure that will link alternative minimum tax relief for the middle class to increased taxes on private equity fund managers. Fair and Equitable Tax Policy for America's Working Families, Hearings before the House Committee on Ways and Means ("Fair and Equitable Tax Hearings"), 110th Congress, 1st Sess (Sept 6, 2007), online at http://waysandmeans.house. gov/hearings.asp?formmode=detail&hearing=584 (visited June 8, 2008). Another hearing is scheduled, which "will focus on a comprehensive examination of Federal income tax fairness, with particular attention to investment fund manager compensation and the effects of the alternative minimum tax on tax rates." House Committee on Ways and Means, Advisory, Chairman Rangel Announces Hearing on Fair and Equitable Tax Policy for America's Working Families, August 30, 2007, online at http://waysandmeans.house.gov/hearmgs. asp?formmode=view&id=6420 (visited June 8, 2008).
12. See also Ryan J. Donmoyer and Peter Cook, Rangel to Push Buyout-Firm Tax Increase in September, Bloomberg News (Aug 3, 2007) (quoting the Ways and Means Committee Chairman, Representative Charles Rangel, as saying this legislation is "top priority"). Representative Levin and thirteen other Democratic representatives, including Representative Rangel, have introduced a bill to treat income from a partnership interest acquired partly in return for "investment management services" as ordinary income.
13. See HR 2834.110th Cong, 1st Sess (June 22, 2007).
14. Ordower, 7 UC Davis Bus L J at 323 (cited in note 1); Daniel Shaviro, Tax Break for Managers of Private Investment Funds, Start Making Sense (May 15, 2007), online at http://danshaviro.blogspot.com/2007/05/tax-break-for- managers-of-private.html (visited June 8, 2008);
15. Daniel Shaviro, Hedge Fund Managers Again, Start Making Sense (June 18, 2007), online at http://danshaviro.blogspot.com/2007/06/hedge-fund- managers-again.html (visited June 8, 2008);
16. Victor Fleischer, Two and Twenty: Taxing Partnership Profits in Private Equity Firms. 83 NYU L Rev (forthcoming 2008). Since the first draft of this paper was circulated and posted in June 2007 (see note t). several other tax scholars have expressed their views in papers, reports, and testimony.
17. A partial list of academic papers includes: Howard E. Abrams, Taxation of Carried Interests, 116 Tax Notes 183, 183-88 (2007);
18. David A. Weisbach, Professor Says the Taxation of Carried Interest Legislation Is Misguided, 116 Tax Notes 505, 505-11 (2007);
19. Noël B. Cunningham and Mitchell L. Engler, The Carried Interest Controversy: Let's Not Get Carried Away, 61 Tax L Rev (forthcoming 2008);
20. David A. Weisbach, The Taxation of Carried Interests in Private Equity. 94 Va L Rev (forthcoming 2008). A partial list of congressional testimony includes: Carried Interest Part I Hearings (cited in note 5) (testimony of Marc P. Gergen, Foundren Foundation Centennial Chair for Faculty Excellence, The University of Texas School of Law); Carried Interest Part II Hearings (cited in note 5) (testimony of Joseph Bankman, Ralph M. Parsons Professor of Law and Business, Stanford Law School); Carried Interest Part III Hearings (cited in note 5) (testimony of Professor Alan J. Auerbach, Robert D. Burch Professor of Law and Economics, University of California, Berkeley).
21. Jenny Anderson and Andrew Ross Sorkin, Congress Weighs End to Tax Break for Hedge Funds, NY Times Al (June 21, 2007) ('"At this moment, the single most important issue for us,' said Doug Lowenstein, president of the Private Equity Council, 'is ensuring that the current-and we believe correct-treatment of carried interest as capital gains is retained.'").
22. See Fleischer, 83 NYU L Rev (forthcoming 2008) (cited in note 6) (describing the compensation of private equity fund managers); Metrick and Yasuda, Economics of Private Equity Funds at 8-14 (cited in note 1) (same); Ordower, 7 UC Davis Bus L J at 346-48 (cited in note 1) (same).
23. Some commentators argue that there is yet a third and even more significant tax benefit, related to the general tax benefit for imputed income. Apparently, the assertion is that some portion of fund managers' service compensation is never taxed in any form. See Fleischer, 83 NYU L Rev (forthcoming 2008) (cited in note 6);
24. Ordower, 7 UC Davis Bus L J at 358-61 (cited in note 1). This Article addresses (and finds no basis for) this third putative advantage in Part III.B.
25. See notes 54-55.
26. Much of the credit belongs to Professor Fleischer. See generally Fleischer, 83 NYU L Rev (forthcoming 2008) (cited in note 6);
27. Ordower, 7 UC Davis Bus L J at 323 (cited in note 1).
28. An earlier literature, sparked by Tax Court adjudication on the taxation of partnership profits interests, also appears to have had a positive impact on public discourse and policy in this area. This literature also remains quite relevant. Contributions to this literature include Laura E. Cunningham, Taxing Partnership Interests Exchanged for Services, 47 Tax L Rev 247 (1991);
29. Leo L. Schmolka, Taxing Partnership Interests Exchanged for Services: Let Diamond/Campbell Quietly Die, 47 Tax L Rev 287 (1991);
30. Mark P. Gergen, Reforming Subchapter K: Compensating Service Partners, 48 Tax L Rev 69 (1992);
31. Henry Ordower, Taxing Service Partners to Achieve Horizontal Equity, 46 Tax Law 19 (1992).
32. Also of importance is the somewhat earlier contribution, Mark P. Gergen, Pooling or Exchange: The Taxation of Joint Ventures between Labor and Capital, 44 Tax L Rev 519 (1989).
33. See also Joseph Bankman, The Structure of Silicon Valley Start-ups, 41 UCLA L Rev 1737 (1994);
34. Ronald J. Gilson and David M. Schizer, Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock, 116 Harv L Rev 874, 890-91 n 57, 908 n 113 (2003).
35. IRC § 1 et seq (2007).
36. This discussion assumes that were the manager compensated in a manner that triggered current income, the fund partnership would not be required to capitalize the cost. As discussed in Part ILA, this assumption can be justified by reference to existing law. Also discussed in Parts ILB and ILC, respectively, is the possibility that the limited partner's deduction would be limited (for example, because it is treated as a "miscellaneous itemized deduction") as well as the possibility that it would be suspended (for example, as a passive loss). Furthermore, Part ILD points out that the effect on the partners' joint employment/self-employment tax base is not zero-sum.
37. This paragraph is an explication of the justification for what is often referred to as the "joint tax perspective." A similar principle has often been applied to other tax issues, though it is oddly neglected in the treatment of private equity profits interests. For examples of where the joint tax perspective has been applied, see Daniel I. Halperin, Interest in Disguise: Taxing the "Time Value of Money," 95 Yale L J 506, 519-24 (1986);
38. Gilson and Schizer, 116 Harv L Rev at 890-91 n 57, 908 n 113 (cited in note 11);
39. Michael S. Knoll, The Tax Efficiency of Stock-based Compensation, 103 Tax Notes 203, 208 (2004) ("Whether a compensation mechanism is taxefficient should be determined from a joint contracting perspective rather than the employer's or employee's perspective alone.");
40. Michael S. Knoll, The Section 83(b) Election for Restricted Stock: A Joint Tax Perspective, 59 SMU L Rev 721 (2006).
41. Treasury Report at 28 n 95 (cited in note 1) (stating that approximately 20 percent of assets invested in private equity funds come from "endowment organizations" and approximately 30 percent come from pension funds). See also Private Equity Council, Press Release, Raising Taxes on Private Equity Investments Could Hurt U.S. Companies and Competitiveness, PEC Tells Congress (July 31, 2007), online at http://www.privateequitycouncil.org/ press-releases/ 2007/07/31/raismg-taxes-on-private-equity-investments-could- hurt-us-companies-and-competitivenesspec-tells-congress (visited June 8, 2008) ("Private equity investment firms between 1991 and 2006 returned more than $430 billion in profits to their investors, nearly half of which are public and private pension funds, university endowments and charitable foundations, [PEC Board Chairman Bruce Rosenblum] said.").
42. This discussion assumes that the income does not generate unrelated business income tax. See IRC § 511 et seq. This tax is generally not imposed upon income from an organization's non-trade or business investment activities, unless the income from such activities is "debt financed." See IRC §§ 512(b) (excepting non-trade or business investment income from the definition of "unrelated business taxable income"), 514 (including "debt-financed" income in the definition of "unrelated business taxable income"). If necessary, the tax-exempt organization can use an offshore "blocker" corporation in a no- or low-tax jurisdiction to avoid either or both: (a) the pass-through of trade or business characterization; (b) pass-through attribution of debt-financing. With regard to the former, see note 101. With regard to the latter, see IRS Private Letter Ruling No 199952086 at 4-5 (1999).
43. Numerous references to this argument populate the transcripts of the recent three-part Senate Finance Committee hearings on carried interest. Carried Interest Part I Hearings (cited in note 5); Carried Interest Part II Hearings (cited in note 5); Carried Interest Part III Hearings (cited in note 5); Carried Interest Part II Hearings (cited in note 5) (testimony of Joseph Bankman, Ralph M. Parsons Professor of Law and Business, Stanford Law School) (stating, in reference to the argument supporting current tax treatment that "the low tax rate on fund managers is consistent with the treatment accorded to inventors and entrepreneurs," that "[e]veryone who testified in favor of capital gain treatment of carry at the July 11 hearing [Carried Interest Part I] compared fund managers to entrepreneurs"). In scholarly circles, the analogy to the supposed tax benefit for sweat equity is equally pervasive.
44. See Weisbach, 116 Tax Notes at 507 (cited in note 6) (" [Entrepreneurs such as founders of companies get capital gains when they sell their shares even if the gains are attributable to labor income. . . . [T]his approach is built deeply into the structure of current law."), 509 ("The tax law makes a fundamental distinction between an employee performing services and an entrepreneur creating or increasing the value of its business. There is little question that a sponsor of a private equity fund is more like an entrepreneur than an employee.");
45. Carried Interest Part II Hearings (cited in note 5) (written testimony of Joseph Bankman, Ralph M. Parsons Professor of Law and Business, Stanford Law School) (accepting the existence of a tax subsidy for entrepreneurs, but suggesting that only small partnerships and not large private equity fund managers are sufficiently analogous to entrepreneurs to merit the same subsidy); Carried Interest Part III Hearings (cited in note 5) (written testimony of Professor Alan J. Auerbach, Robert D. Burch Professor of Law and Economics, University of California, Berkeley) (similar).
46. See also generally Fleischer, 83 NYU L Rev (forthcoming 2008) (cited in note 6) (affirming the existence of the deferral and conversion benefits conventionally associated with the term "sweat equity," but generally using that term to describe a different type of supposed subsidy, discussed in the present Article below and in Part III.B).
47. Alan S. Blinder, The Under-taxed Kings of Private Equity, NY Times BU4 (July 29, 2007). Professor Blinder uses the figure 38 percent because he is including the effect of employment taxes. See Part ILD.
48. Carried Interest Part III Hearings (cited in note 5) (written testimony of Russell Read, Chief Investment Officer, California Public Employees' Retirement System) (emphasizing the negotiated and variable terms of private equity partnership agreements, and predicting that tax reform would indirectly affect private equity investors like pensions); Carried Interest Part III Hearings (cited in note 5) (written testimony of Professor Alan J. Auerbach, Robert D. Burch Professor of Law and Economics, University of California, Berkeley) ("[T]he ultimate burden of this tax increase may be borne at least partially by others in the economy, notably by the investors in the affected funds, including pension funds and, ultimately, by these funds' beneficiaries.").
49. Alicia Mundy, Private-equity Tax Measure Could Cut into State Pensions, Seattle Times B1 (July 31, 2007) ("[S]ome of the state's contracts with private-equity funds require the state to pay the fund managers' tax bills, said State Treasurer Michael Murphy.").
50. Jenny Anderson, Scrutiny on Tax Rates That Fund Managers Pay, NY Times C3 (June 13, 2007) (quoting former Treasury Secretary Robert Rubin at a recent Brookings Institution event: "It seems to me what is happening is people are performing a service, managing peoples' money in a private equity form, and fees for that service would ordinarily be thought of as ordinary income.");
51. House Ways and Means Committee, Press Release, Levin, Democrats Introduce Legislation to End Carried Interest Tax Advantage: Bill Seeks Fairness in Tax Code (June 22, 2007), online at http://waysandmeans.house.gov/News. asp?FormMode=print&ID=532 (visited June 8, 2008), quoting bill sponsor Representative Sandy Levin: Investment fund employees should not pay a lower rate of tax on their compensation for services than other Americans. These investment managers are being paid to provide a service to their limited partners and fairness requires they be taxed at the rates applicable to service income just as any other American worker.
52. See also Fleischer, 83 NYU L Rev (forthcoming 2008) (cited in note 6) ("Distributive justice is also a concern for those who believe in a progressive or flat rate income tax system. This quirk in the partnership tax rules allows some of the richest workers in the country to pay tax on their labor income at a low effective rate."). But see id at 39 ("The best tax design for the taxation of partnership profits depends . . . on [among other things] . . . whether we take the capital gain preference as a given.").
53. See note 195 for a discussion of the estate tax and the income taxation of gifts and bequests.
54. See, for example, Fleischer, 83 NYU L Rev (forthcoming 2008) (cited in note 6).
55. Carried Interest Part II Hearings (cited in note 5) (testimony of Joseph Bankman, Ralph M. Parsons Professor of Law and Business, Stanford Law School).
56. The general partner of the fund is itself typically a partnership, namely the "private equity firm." Nevertheless, we shall treat the general partner as an individual. Ignoring the additional layer of partnership structure does not affect our analysis, because, for our purposes, the missing partnership would be a purely pass-through entity.
57. See, for example, Knoll, 103 Tax Notes at 208-09 (cited in note 14).
58. A formulaic web appendix, which is available online at http://www.cstone.net/~csanchir/ Sanchirico-Private-Equity-Web-Appendix-082307. pdf (visited June 8, 2008), generalizes several features of the base case example, including the amount of the contributions, the amount of salary, the allocative shares of the salary expense deduction, and the form in which capital gains income from the profits interest is realized (whether by pass-through or liquidation).
59. The analysis is not qualitatively affected by regarding a larger or smaller portion of the fund manager's ultimate $3 million return as salary.
60. Some commentators are critical of what private equity funds do to companies once they obtain control. We will put this potentially important issue to one side in order to focus specifically on the tax treatment of profits interests.
61. We adopt this simplifying assumption even though the tax treatment of profits interests turns in part on difficulties of valuation and on the extent to which the interest is vested. For a discussion of the tax law, see notes 54-55. The policy significance of the riskiness of profits interests is considered below in Part V.D.
62. SEC Report at 7-8 (cited in note 1) ("Private equity funds are long-term investments, provide for liquidation at the end of the term specified in the fund's governing documents, and offer little, if any, opportunity for investors to redeem their investments. A private equity fund, however, may distribute cash to its investors when it sells its portfolio investment, or it may distribute the securities of a portfolio company . . . to its investors."); Treasury Report at 28 & n % (cited in note 1) (noting that the average lifespan of a private equity fund is ten to twelve years, determined by agreement in the partnership papers).
63. See the formulaic web appendix to this Article, online at http://www.cstone.net/~csanchir/ Sanchirico-Private-Equity-Web-Appendix-082307. pdf (visited June 8, 2008) (cited in note 27).
64. For a helpful discussion of how profits interests are structured, see Ordower, 7 UC Davis Bus L J at 345-52 (cited in note 1).
65. The key examples in Fleischer, 83 NYU L Rev (forthcoming 2008) (cited in note 6), do not appear to satisfy this requirement.
66. Or so we shall stipulate, ignoring the question of whether there is any difference across the two plans in the performance incentives they offer to general partners.
67. IRC § 701 ("A partnership as such shall not be subject to the income tax imposed by this chapter. Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities.").
68. IRC § 703(a) ("The taxable income of a partnership shall be computed in the same manner as in the case of an individual except [for several modifications].").
69. Such allocations are generally made according to the partnership agreement. IRC § 704(a). However, not all such allocations will be respected for tax purposes. See IRC § 704(b). A complex set of regulations determines whether a given allocation will be sustained. See Treas Reg § 1.7044(b) (2007).
70. Some additional simplifying assumptions: First, we will assume that both partners and the partnership have the same taxable years. Otherwise, see IRC § 706(a). Second, we will assume that both partners and the partnership are cash method taxpayers. Removing these assumptions would complicate the analysis, but would not affect the basic findings.
71. IRC § 61(a)(1) (including "[compensation for services" in gross income).
72. IRC §§ 703(a) (stating that "[t]he taxable income of a partnership shall be computed in the same manner as in the case of an individual," but for certain modifications), 162(a)(1) (allowing a deduction for "reasonable allowance for salaries or other compensation for personal services actually rendered").
73. See note 38. The proper allocation may be difficult to determine, but the magnitude of this allocation affects only the magnitude of the "swap," not its nature or existence. See Part I.B.3.d. Note also that under § 704(d), "[a] partner's distributive share of partnership loss (including capital loss) shall be allowed only to the extent of the adjusted basis of such partner's interest in the partnership at the end of the partnership year in which such loss occurred." IRC § 704(d) (emphasis added). As we shall see, the general partner's adjusted basis at the end of this first taxable year will account for her contribution of cash salary.
74. IRC § 704 (defining the partner's distributive share). Contrast a partner's "distributive share" of an item of partnership income, loss, deduction, and so forth, with a "distribution" to the partner of partnership property, as governed by IRC §§ 731-37.
75. IRC § 162(a)(1) (allowing as a deduction "a reasonable allowance for salaries or other compensation for personal services actually rendered").
76. That is, she deducts it from her gross income in determining adjusted gross income, as opposed to deducting it from adjusted gross income in determining taxable income. IRC § 62(a)(1) (stating that this deduction is above the line). What is important for our purposes is that a dollar of allocated salary expense has an impact on adjusted gross income that is equal and opposite to a dollar of salary received. See Part ILB for additional discussion regarding the potential above-the-line nature of this deduction.
77. IRC §§ 1221(a) (defining capital assets), 1222 (defining capital gains and losses).
78. IRC § 722 (defining the basis of a contributing partner's interest). A partner's basis in her interest in the partnership is sometimes called her "outside" basis.
79. IRC § 705(a)(2)(A) (directing that a partner's basis be decreased by partnership losses).
80. IRC § 731 (governing the extent of recognition of gain or loss on the distribution of assets).
81. IRC §§ 731 (prescribing that gain or loss from a liquidating distribution be treated as gain or loss from the sale or exchange of a partnership interest), 741 (stating that gain or loss from the sale or exchange of a partnership interest should be "considered as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in § 751 (relating to unrealized receivables and inventory items)"). We are assuming that IRC § 751 does not apply.
82. IRC § 1001(b) ("The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received.").
83. IRC § 1001(a) (prescribing the computation of gain or loss).
84. We are assuming that holding period requirements are met. IRC § 1222(1)-(4). Note that "year two" may be more than one year after "year one."
85. Revenue Procedure 93-27 specifies that, subject to certain exceptions, if a partner receives a profits interest in return for the provision of services to a partnership, the receipt of such an interest is not a taxable event for the partner or the partnership. See Rev Proc 93-27, 1993-2 Cum Bull 343.
86. See also generally Rev Proc 200143, 2001-2 Cum Bull 191 (clarifying Rev Proc 93-27).
87. This tax treatment is conditioned on the following two requirements, both of which would generally be met by profits interests-if not by the artificially simple example that we are considering. First, in providing her labor contribution, the general partner must be regarded as acting "in a partner capacity." Rev Proc 93-27, 1993-2 Cum Bull 344;
88. IRC § 707(a)(2)(A). Partners who provide "management services," such as the general partner in our example, are generally regarded as acting "in a partner capacity." Rev Rul 81-300, 1981-2 Cum Bull 144;
89. Pratt v Commissioner of Internal Revenue, 64 Tax Ct 203 (1975) (finding that partners providing management services were acting in a partner capacity), affirmed in part, reversed in part, 550 F2d 1023 (5th Cir 1977).
90. Compare Rev Rul 81-301, 1981-2 Cum Bull 144 (stating that a general partner was not acting "in partner capacity" when the services the general partner provided to the partnership were substantially the same as those the general partner provided to others as an independent contractor or agent). Second, the service-compensatory payments must not be considered "guaranteed payments" under IRC § 707(c). "Guaranteed payments" include service-compensatory payments to a partner that are determined without regard to the "income of the partnership." The word "income" in § 707(c) means net income, which is to say profits. Id. Profits interests are determined with regard to the "income of the partnership," and so are generally not guaranteed payments even to the extent that they are service-compensatory.
91. Compare id with Rev Rul 81-300, 1981-2 Cum Bull 144 (stating that "guaranteed payments" need not be fixed payments and holding that compensation based on gross income, as opposed to profits, may be a "guaranteed payment").
92. Proposed regulations would apply IRC § 83 to the general partner's receipt of her profits interest. Proposed Treas Reg § 183-3(1) (2005). Such a profits interest-in practice, if not in our artificially simplified example-would generally be regarded as "substantially nonvested" under IRC § 83. Proposed Treas Reg § 183-3(b)-(d). See also IRC § 83. The general partner could elect under IRC § 83(b) to take the value of such partnership interest into current ordinary income as compensation for services. Importantly, in doing so, the general partner would be permitted to calculate the value of the profits interest according to the "liquidation" method. Proposed Treas Reg § 1.83-3(1). Under this method, the value of the profits interest would equal what that interest would garner for the general partner were the partnership liquidated immediately after she received her profits interest. Specifically, the profits interest would be valued at (or near) zero. See also Campbell v Commissioner of Internal Revenue, 943 F2d 815, 823 (8th Cir 1991) (finding that a taxpayer's profits interest lacked current value). Therefore, the general partner would have no salary income in year one. Further, the general partner would take a zero basis in her partnership interest. Treas Reg § 1.704-1(b)(2)(iv)(1) (describing transfers of partnership interests).
93. And IRC § 83 would then not apply to the realization of her partnership interest in year two. See also Notice 200543, 2005-24 Int Rev Bull 1221 (describing a proposed revenue procedure rendering obsolete Rev Proc 93-27 and Rev Proc 200143);
94. note 54 (describing Rev Proc 93-27).
95. The Treasury lists finalization of these proposed regulations in its "Priority Guidance Plan" for the year ending June 30, 2007. Department of the Treasury, First Periodic Update of the 2006-2007 Priority Guidance Plan 23 (March 12, 2007), online at http://www.irs.gov/pub/irs-utl/2006- 2007pgp.pdf (visited June 8, 2008).
96. This is the case under current law, as described in note 54. See also Rev Proc 93-27, 1993-2 Cum Bull 343 (stating that the receipt of a profits interest is a nontaxable event for the partnership also);
97. Rev Proc 2001-43, 2001-2 Cum Bull 191 (clarifying Rev Proc 93-27). This is also true under proposed regulations, as described in note 55 and IRC § 83(h).
98. IRC § 722 (defining the basis of a contributing partner's interest).
99. IRC § 1001 (governing the determination of amount of and recognition of gain or loss). Again, we assume that holding period requirements are met. IRC § 1222(1)-(4). Recall that "year two" may be more than one year after "year one."
100. IRC §§ 703(a) (directing that taxable income of a partnership be computed in the same manner as in the case of an individual, but for certain modifications), 162(a)(1) (allowing a deduction for a "reasonable allowance for salaries or other compensation for personal services actually rendered"), 704 (governing allocations of partnership items of deduction); Treas Reg § 1.704-1 (same).
101. IRC § 704 (governing allocations of partnership items of deduction); Treas Reg § 1.704-1 (same). See, in particular, the definition of "economic effect" in Treas Reg § 1.704-1(b)(2).
102. IRC § 62(a)(1) (allowing above-the-line deduction for nonemployee trade or business expenses). See Part II.B. for additional discussion regarding the above-the-line nature of this deduction.
103. IRC §§ 1221(a) (defining capital assets), 1222 (defining capital gains and losses).
104. IRC § 722 (governing the basis of a contributing partner's interest).
105. IRC § 705(a)(2)(A) (prescribing that a partner's basis is decreased by his distributive share of partnership losses).
106. IRC § § 731 (treating gain or loss from liquidating distribution as gain or loss from the sale or exchange of partnership interest), 741 (considering gain or loss from sale or exchange of partnership interest "as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in section 751 (relating to unrealized receivables and inventory items)"), 1001 (governing the determination of the amount of and recognition of gain or loss). Again, we are assuming that IRC § 751 does not apply.
107. See notes 54-56.
108. See notes 63-65.
109. See note 58.
110. Online at http://www.cstone.net~csanchir/Sanchirico-Private-Equity-Web- Appendix082307.pdf (visited June 8, 2008) (cited in note 27).
111. IRC §§ 704 (governing allocation of partnership income, including capital gains), 705 (governing adjustments to a partner's basis in her partnership interest for her distributive share of partnership income).
112. IRC § 67 (defining "miscellaneous itemized deductions" and allowing them only to the extent that their aggregate exceeds 2 percent of adjusted gross income).
113. I thank Michael Knoll for suggesting, with regard to the June 2007 draft of this Article, that the issue of whether capitalization would be required deserved greater attention.
114. IRC § 263 (disallowing deductions for certain capital expenditures); INDOPCO, lne v Commissioner of Internal Revenue, 503 US 79, 88-89 (1992) ("Although the mere presence of an incidental future benefit . . . may not warrant capitalization, a taxpayer's realization of benefits beyond the year in which the expenditure is incurred is undeniably important.");
115. Encyclopaedia Britannica, lne v Commissioner of Internal Revenue, 685 F2d 212, 214 (7th Cir 1982) ("The object of sections 162 and 263 of the Code, read together, is to match up expenditures with the income they generate.").
116. This occurs when capitalized costs are either: (a) not recovered in the form of deductions from ordinary income or the like-such as for depreciation, amortization, or the cost of goods sold; or (b) are so recovered, but then are subject to "recapture" upon sale or disposition of the asset. See IRC §§ 167 (allowing deduction for depreciation of certain business or incomeproducing assets), 168 (determining the magnitude of the § 167 depreciation deduction for certain tangible property), 197 (allowing an amortization deduction for certain business or incomeproducing intangibles), 263A (requiring capitalization of inventory costs and the cost of producing real or tangible property used in a trade or business or income producing activity), 61(a)(2) (including "gross income derived from business" in the definition of gross income); Treas Reg 1.61-3(a) (allowing the subtraction of "cost of goods sold" from revenues in determining "gross income derived from business" under IRC § 61(a)(2)). See also IRC §§ 1245 (requiring ordinary income treatment of gains from disposition of certain depreciable property to the extent of depreciation deductions previously taken), 1250 (providing a similar, but more limited recapture rule for certain depreciable realty).
117. See Encyclopaedia Britannica, 685 F2d at 217: If one really takes seriously the concept of a capital expenditure as anything that yields income, actual or imputed, beyond the period (conventionally one year) in which the expenditure is made, the result will be to force the capitalization of virtually every business expense. It is a result courts naturally shy away from. It would require capitalizing every salesman's salary, since his selling activities create goodwill for the company and goodwill is an asset yielding income beyond the year in which the salary expense is incurred. (citations omitted).
118. Treas Reg §§ 1.263(a)-4,-5.
119. Were the fund manager's services employed in creating tangible assets (an unlikely or at least exceptional scenario), then a set of rules different from those discussed in notes 78-80 would apply. See text accompanying note 84.
120. Treas Reg § 1.263(a)-5(a) (requiring capitalization of amounts paid to facilitate, among other things: (a) the acquisition of the assets that constitute a trade or business; (b) the acquisition of, roughly speaking, majority ownership in a trade or business; or (c) a restructuring, recapitalization, or reorganization of the capital structure of a business entity); Treas Reg § 1.263(a)-4(b)(1)(iv) (requiring capitalization of amounts paid to facilitate, among other things: (a) the acquisition of, roughly speaking, nomnajority ownership in a business venture; or (b) the acquisition of intangible assets not in connection with the acquisition of the assets that constitute a trade or business). See Treas Reg § 1.263(a)-5(b)(2) for "ordering rules" regarding the application of Treas Reg §§ 1.263(a)4, -5.
121. Treas Reg § 1.263(a)-5(d) (adopting the "simplifying convention" that "employee compensation" does not constitute a payment made to facilitate the transactions listed in Treas Reg § 1.263(a)-5(a), as described in note 78); Treas Reg § 1.263(a)-5(d)(2)(ii) (defining "employee compensation" to include "guaranteed payments to a partner"); Treas Reg § 1.263(a)4(e)(4), (e)(4)(ii)(B) (similar exception for capitalization requirements in Treas Reg § 1.263(a)4(b)(1)(iv), described in note 78). The fund manager's salary under the cash salary reinvestment plan would most likely be considered a "guaranteed payment to a partner." IRC § 707(c). See note 54 for a discussion of such "guaranteed payments."
122. Treas Reg § 1.263(a)4(b)(1)(iii) (requiring capitalization of the cost of creating or enhancing a "separate and distinct intangible asset"); Treas Reg § 1.263(a)4(b)(3)(i) (defining "separate and distinct intangible asset"), quoted in note 81. Were an alternative "future benefits" test for capitalization applied, it would probably point toward capitalization of salary paid to enhance goodwill. This future benefits test was famously employed by the Supreme Court in INDOPCO, 503 US at 88 (requiring capitalization of investment banker fees connected with a merger because such fees produced benefits beyond the current year), 87 (asserting that the creation of a separate and distinct asset is sufficient but not necessary for capitalization, and pointing to the existence of future benefits as another consideration). However, in promulgating Treas Reg §§ 1.263(a)4, -5 in the wake of INDOPCO, the Treasury and the IRS seem to have eschewed INDOPCO's "future benefits test," at least for the time being. See Treas Reg § 1.263(a)4(b)(1)(iv) (requiring capitalization of an "amount paid to create or enhance a future benefit identified in published guidance in the Federal Register or in the Internal Revenue Bulletin") (emphasis added);
123. TD 9107, 2004-7 Int Rev Bull 447: [Section 1.263(a)-4 provides] that an amount paid to acquire or create an intangible not otherwise required to be capitalized by the regulations is not required to be capitalized on the ground that it produces significant future benefits for the taxpayer, unless the IRS publishes guidance requiring capitalization of the expenditure. If the IRS publishes guidance requiring capitalization of an expenditure that produces future benefits for the taxpayer, such guidance will apply prospectively. While most commentators support this approach, some commentators expressed concerns that this approach, particularly the prospective nature of future guidance, will permit taxpayers to deduct expenditures that should properly be capitalized. The IRS and Treasury Department continue to believe that the capitalization principles in the regulations strike an appropriate balance between the capitalization provisions of the Code and the ability of taxpayers and IRS personnel to administer the law, and are a reasonable means of enforcing the requirements of section 263(a). (emphasis added). The IRS appears to have published no guidance requiring capitalization on the ground that an outlay produces future benefits.
124. Treas Reg § 1.263(a)4(b)(3)(i) (defining "separate and distinct intangible asset" as "a property interest of ascertainable and measurable value in money's worth that is subject to protection under applicable ... law and the possession and control of which is intrinsically capable of being sold, transferred or pledged (ignoring any restrictions imposed on assignability) separate and apart from a trade or business"). With specific regard to renegotiating labor contracts, see Treas Reg § 1.263(a)-4(b)(3)(ii) (treating outlays to facilitate contract termination or renegotiation as not creating or enhancing a separate and distinct asset).
125. For the importance of this second condition, see note 84 and accompanying text.
126. In fact, a full $1 million of adjusted gross income would be converted from year one ordinary income into year two capital gains. Under the cash salary reinvestment plan, the general partner would also presumably have to capitalize her distributive share qua partner of the salary that she was taking fully into income qua service provider. She would thus have $1 million of ordinary income in year one under that plan. Compare this to the $900,000 of net salary income (that is, net of the general partner's distributive share of the salary expense deduction) that is converted in moving from the (noncapitalized) cash salary reinvestment plan to the imputed salary plan, as described in Part I.B.
127. For example, costs that must be capitalized under IRC § 263A, the so-called Unicap rules, will be recovered as "cost of goods sold" (if incurred to produce or acquire property that is inventory in the hands of the taxpayer) or as depreciation (if incurred to produce real or tangible property used in a trade or business, or an activity for the production of income, that is not inventory in the hands of the taxpayer). See IRC §§ 263A, 167-68 (allowing and determining magnitude of deduction for depreciation of certain business or income-producing assets). Furthermore, intangible assets are often amortizable. See IRC § 197 (allowing amortization of specific intangibles including acquired goodwill, intellectual property, work force in place, and government licenses); Treas Reg § 1.167(a)-3 (allowing amortization of intangibles known to have a limited useful life). To be sure, recapture rules may apply. See IRC §§ 1245 (requiring ordinary income treatment of gains from disposition of certain depreciable property to the extent of depreciation deductions previously taken), 1250 (providing a similar, but more limited recapture rule for certain depreciable realty). But recapture will not prevent the recovery from ordinary income of costs paid for an asset to the extent that the value of the asset truly declines over time. For example, if the depreciation allowances (and the corresponding basis reductions) for an item of "§ 1245 property" keep pace with the actual decline in the asset's fair market value, then there is no gain upon disposition and no recapture. See IRC § 1245(a) (determining amount of recapture).
128. IRC § 63(d) defines the term "itemized deductions" as follows: any deduction, other than the deduction for personal exemptions under IRC § 151, that is not subtracted from gross income in calculating adjusted gross income under IRC § 62.
129. Another limitation with similar effect, and subject to similar analysis, arises with respect to carrying nonbusiness losses to other taxable years. This limitation is discussed in note 94.
130. IRC § 67.
131. IRC § 68(a)-(b). This phase-out on adjusted gross income is itself phasing out over time. See IRC § 68(f)-(g). However, this phase-out over time (of the phase-out on adjusted gross income) "sunsets" on December 31, 2010. See Economic Growth and Tax Relief Reconciliation Act of 2001 § 103, Pub L No 107-16, 115 Stat 38, 44 (adding § 68 (f)-(g)), § 901, 115 Stat at 150 (general sunset provision for the Act applicable to the Act's addition of § 68(f)-(g)). For tax year 2007, § 68 reduces certain otherwise allowable itemized deductions by no more than 53 1/3 percent. For tax year 2008, the reduction is no more than 26 2/3 percent. The reduction in allowable deductions imposed by § 68 is made after, and in addition to, the reduction imposed by § 67. See IRC § 68(d).
132. IRC § 56(b)(1)(A)(i). Note that deductions so prohibited are not "carried forward" in the form of a "minimum tax credit" against future years' regular tax liability under § 53. See IRC § 53(d)(1)(B)(ii)(I).
133. These limitations would be imposed at the partner level only. Treas Reg 1.702-1(a)(8) (requiring certain items of partnership income and loss to be "separately stated," including expenses for the production of income under § 212); Temp Treas Reg 1.67-2T(b) (instructing that the § 67 limit on miscellaneous itemized deductions be applied at the partner level and not at the partnership level); Treas Reg 1.58-2(b) (clarifying that partnerships per se are not subject to the alternative minimum tax). See also IRC § 68(d) (specifying that § 68's limits are applied after those imposed by § 67). A separate issue is the level at which deductions would be characterized for purposes of applying these limits at the partner level. This is discussed in the text to follow.
134. IRC § 212 (allowing a deduction for expenses paid or incurred for the production of income). Thanks to NYU Tax Symposium participants, and to Mitchell Engler in particular, for inspiring me to further investigate this issue and expand this discussion.
135. But not always. Section 212 expenses "attributable to property held for the production of rents or royalties" are subtracted from gross income in calculating adjusted gross income. IRC § 62(a)(4). They are, therefore, not itemized deductions. IRC § 63(d). Consequently, they are also not miscellaneous itemized deductions. See IRC § 67(b).
136. Higgins v Commissioner of Internal Revenue, 312 US 212, 213-14 (1941) (denying an individual taxpayer a trade or business expense deduction under the precursor to § 162 for "salaries and expenses incident to looking after" his investments in stocks and bonds);
137. Commissioner of Internal Revenue v Groetzinger, 480 US 23, 30 n 9 (1987) (stating that Congress added § 212 to permit a deduction (now limited) for expenses ruled nondeductible as trade or business expenses in Higgins).
138. Also turning on trade or business characterization is another kind of deduction limit, the limit on carrying non-trade or business losses to other taxable years, as mentioned in note 86. If a taxpayer's allowable deductions exceed his gross income, his deductions are to this extent effectively disallowed in the current taxable year. IRC § 1 (providing tax schedules wherein zero is the lowest level of taxable liability). Unused deductions, however, may be applied to other taxable years in the form of net operating loss carrybacks or carryovers. IRC § 172(a). However, for noncorporate taxpayers, unused non-trade or business losses may only offset non-trade or business gross income in calculating the carryable net operating loss derived from any given year. IRC § 172(d)(4). This raises the possibility that non-trade or business losses will be permanently disallowed, rather than merely suspended. This scenario would not apply to the limited partner's deduction-even if the limited partner is a noncorporate taxpayer with an overall loss in the current year-if the losses were regarded as having been incurred in the conduct of a trade or business. The definition of "trade or business" is the same for purposes of applying § 172(d)(4) as it is for applying § 162(a), which is discussed in the text. Malchin v Commissioner of Internal Revenue, 42 Tax Ct Mem Dec (CCH) 847, 847 (1981).
139. IRC § 62(a)(1).
140. IRC § 63(d).
141. IRC § 702(b); Tallal v Commissioner of Internal Revenue, 778 F2d 275, 276 (5 th Cir 1985) ("When the taxpayer is a member of a partnership, we have interpreted § 702(b) to require that business purpose must be assessed at the partnership level. Accordingly, for the purpose of determining whether an expense is deductible under § 162(a), the partnership's motive controls, not an individual partner's motive for joining the partnership.") (citations omitted);
142. Barham v United States, 301 F Supp 43, 44-47 (MD Ga 1969) (*'[F]or the purpose of determining the nature of an item of income, deduction, gain, loss or credit (in the hands of a distributee partner, as well as in the hands of the partnership before distribution), the partnership is to be viewed as an entity and such items are to be viewed from the standpoint of the partnership ... rather than from the standpoint of each individual member."), affirmed per curiam, 429 F2d 40, 41 (5th Cir 1970);
143. Brannen v Commissioner of Internal Revenue, 78 Tax Ct 471, 505 (1982) ("Based on the holdings of the numerous cases above discussed, we conclude that the issue of whether an activity carried on by a partnership amounts to a trade or business must be determined at the partnership level"), affirmed, 722 F2d 695 (11th Cir 1984).
144. IRC § 702(b); Treas Reg § 1.702-1(b) (noting that "[t]he character in the hands of a partner of any item of income, gain, loss, deduction, or credit ... shall be determined as if such item were realized directly from the source from which realized by the partnership or incurred in the same manner as incurred by the partnership," and providing as an example the partnership-level determination of whether an asset is used in a trade or business for purposes of determining whether gain from the sale thereof is taxed at favorable rates by virtue of IRC § 1231). It is important to distinguish the case in which an expense is, at the partnership level, a miscellaneous itemized deduction, such as might arise under § 212. That characterization would likewise flow through to the partners. See IRC § 67(c); Treas Reg § 1.67-2T(a).
145. Higgins, 312 US at 217.
146. See also Groetzinger, 480 US at 32, 36 (emphasizing the factual nature of the determination).
147. Groetzinger, 480 US at 35.
148. What if the underlying business is in corporate form? If the business is in corporate form and the private equity fund holds shares in such corporation, the trade or business of the corporation will not be imputed to the private equity fund. Whipple v Commissioner of Internal Revenue, 373 US 193, 202 (1963). This does not establish that the private equity partnership is not engaged in a trade or business. Id at 203435 (leaving open the possibility that a supra-majority shareholder may be engaged in trade or business related to her shareholdings but distinct from any imputation of the corporation's trade or business.). However, it would seem to make trade or business characterization less likely. Thus, holding investments in corporate form may help to avoid trade or business characterization when such characterization would generate unrelated business income tax for tax-exempt limited partners. See IRC § 511 et seq (imposing unrelated business income tax). Note in this regard that the participation of taxable and tax-exempt investors may be differently structured under separate partnership agreements. See note 163 regarding the existence of varying agreements across investors. Note also that blocking the pass-through of trade or business character might also be achieved by interposing a corporation between the tax-exempt entity and its participation in the private equity partnership, as opposed to interposing a corporation between the private equity partnership and its investment in the underlying business. See note 16 for a discussion of this latter form of "blocker" corporation.
149. Groetzinger, 480 US at 31,
150. citing Higgins, 312 US 212,
151. City Bank Farmers Trust Co v Helvering, 313 US 121 (1941),
152. and United States v Pyne, 313 US 127 (1941).
153. Compare Andrew Needham, 95 Tax Notes 1215, 1230 n 89 (2002) (citing Higgins to support the proposition that the fund partnership would not be regarded as engaged in a trade or business).
154. 312 US 212 (1941).
155. Id at 214.
156. Id at 218.
157. For a more recent case that is similarly distinguishable, see Schmidt v Commissioner of Internal Revenue, 46 Tax Ct Mem Dec (CCH) 1586, 1586 (1983) (denying a § 162 deduction for a partner's distributive share of a partnership's construction cost overruns based on the finding that the partnership was not engaged in a trade or business, and basing this finding on the taxpayers' failure to produce sufficient evidence that the partnership took an active role in the construction project, or indeed "engaged in any activity, supervisory or otherwise").
158. Higgins, 312 US at 213-14.
159. A separate issue is whether, if such businesses are held in corporate form, the trade or business of the corporation will be imputed to the active controlling shareholder. As noted, Whipple, 374 US at 202, holds against imputation across the corporate boundary. But the same case leaves open the possibility that the controlling shareholder is engaged in a separate trade or business in his individual capacity.
160. Id at 203-05.
161. Metrick and Yasuda, The Economics of Private Equity Funds at 7 (cited in note 1) (concluding, based on extensive survey data, that the "median [venture capital] fund expects to make 20 investments, which yields five investments per partner at that fund. . . . [E]ach investment typically requires significant work from a venture capitalist. . . [Buyout funds] tend to make larger investments and require even more intense involvement on each one, with the median fund making only 12 investments, or 2.4 per partner").
162. See generally Thornton, What's Bigger than Cisco, Coke, or McDonald's?, Bus Wk at 100-10 (cited in note 1) (offering a rare journalistic account of how private equity firms operate).
163. Rev Rul 75-523, 1975-2 Cum Bull 257 (holding that ministerial expenses of a partnership formed to invest in securities are deductible under § 212 and not § 162).
164. See the second paragraph of note 101 regarding tax-exempts, unrelated business income, and blocker corporations.
165. See note 99.
166. See note 100.
167. Note also that, as discussed in note 90, these limitations would be applied only at the partner level.
168. IRC § 705(a)(2)(A).
169. If one ignores the effect on the general partner's distributive share of the deduction, one can also easily conceive of this effect in terms of rate differences across the partners. In particular, one views the limited partner's marginal tax rate on year one ordinary income to be zero. With respect to conversion, we will do just this in Part III.E.2. If one accounts for the general partner's distributive share of the deduction, however, reconceiving of the effect in terms of rate differences is possible but less convenient, as it would require introducing two rates on ordinary income: one for deduction and one for inclusion.
170. See DiTunno v Commissioner of Internal Revenue, 80 Tax Ct 362, 372 n 14 (1983) ("Congress was evidently surprised at the result in Higgins . . . . By enacting sec. 212, the Congress intended to restore meritorious deductions which Higgins denied.").
171. Section 67, limiting miscellaneous itemized deductions, was enacted in 1986. See An Act to Reform the Internal Revenue Laws of the United States, Pub L No 99-514, 100 Stat 2085 (1986). Section 68, imposing an overall limit on itemized deductions, was enacted in 1990. See An Act to Provide for Reconciliation Pursuant to Section 4 of the Concurrent Resolution on the Budget for Fiscal Year 1991, Pub L No 101-508, 104 Stat 1388 (1990). The alternative minimum tax was enacted in 1969. See An Act to Reform the Income Tax Laws, Pub L No 91-172, 83 Stat 487 (1969), codified at IRC § 55.
172. 80 Tax Ct 362 (1983).
173. Id at 372 n 14, quoting 88 Cong Rec 6376 (1942).
174. 480 US 23 (1987).
175. Id at 29-30.
176. IRC § 705(a)(2)(A).
177. For a discussion of how capitalization might be combined with ordinary income cost recovery, see note 84 and accompanying text.
178. IRC §§ 1211(a) (imposing capital loss limits for corporations), 1212(a) (allowing carryback and carryforward of capital losses for corporations), 1211(b) (imposing capital loss limits for noncorporate taxpayers), 1212(b) (allowing carry forward of capital losses for noncorporate taxpayers), 702(a)(1)-(2) (requiring a partner to separately account for partnership capital gains and losses).
179. IRC § 465 (limiting taxpayer's deductions for "losses" to the amount she has "at risk"; discussed in more detail in note 127); Treas Reg § 1.702-1 (a)(8)(h) (requiring a partner to separately account for items of partnership income and loss whenever such separate accounting results in different tax liability).
180. The "at-risk" rules (IRC § 465) are also unlikely to limit the general partner in taking her distributive share of the deduction. The general partner is allowed losses from the partnership only to the extent to which she is "at-risk" in the partnership enterprise. IRC § 465(a), (c). "Losses" are defined for purposes of § 465 in IRC § 465(d). Section 465(d) does not define "losses" to be (otherwise) allowable deductions allocable to the activity. Rather, it defines "losses" as the excess of such deductions over "income received or accrued by the taxpayer during the taxable year from such activity." Presumably, the general partner's salary income would qualify as "income received or accrued by the taxpayer during the taxable year from such activity." Therefore, netting the deduction against the salary, there would be no "loss" for purposes of § 465.
181. IRC § 704(d) (limiting a partner's distributive share of partnership losses to partner's adjusted basis in partnership).
182. IRC § 469(c), (h) (defining "passive activity" and "material participation"), 469(a), (d), (g) (allowing, in any taxable year, deductions derived from a passive activity only to the extent of net income, if any, (not counting such deductions), from all passive activities in such taxable year, or upon a fully tax-recognized disposition of the taxpayer's entire interest in the particular passive activity), 469(b) (treating losses disallowed by § 469(a) as passive losses in the next tax year). In the typical private equity scenario, it seems likely that the partnership enterprise would be deemed a passive activity for the limited partner. See IRC § 469(c), (c)(1)(A), (c)(1)(B) (defining "passive activity" to generally include any activity in connection with a trade or business or the production of income in which taxpayer does not "materially participate"), 469(h)(1) (defining "material participation" generally). See also IRC § 469(h)(2), (1) (3); Temp Treas Reg § 1.469-5T(a)(1), (a)(5), (a)(6), (e)(3), (d) (deeming the limited partner to not materially participate in the partnership enterprise, unless, roughly speaking, the limited partner participates more than 500 hours in the activity in the current year or in any five of the last ten years). See also IRC § 469(c)(2), (c)(4), (j)(8) (defining "rental activities" to be those "where payments are principally for the use of tangible property," and deeming rental activities passive without regard to whether the taxpayer materially participates), which is only partially modified by IRC § 469(c)(7) (restoring the material participation test, including its special application to limited partners, for rental real estate trades or businesses, if a substantial portion of the taxpayer's personal services supplied to any trade or business are supplied to the class of rental real estate trades or businesses).
183. This could occur, despite the hypothesized existence of offsetting passive income, were the deductions attributable to nonpassive activities in excess of the gross income attributable to such nonpassive activities.
184. IRC § 172(c) (defining "net operating loss"), 172(a)-(b) (allowing two year carryback and 20 year carryover of net operating losses). Note that the limited partner's distributive share of the salary expense deduction would most likely count toward her net operating loss, and so be available for carryback or carryover. See note 94 and accompanying text.
185. Sections 3201-41 of the Internal Revenue Code impose two taxes on "wages" for each of employers and employees. See IRC § 3121(a) (defining "wages"). The first tax is for purposes of providing old-age, survivors, and disability insurance (commonly referred to as "social security"). This tax is imposed once on the employee and once on the employer, in each case at a rate of 6.2 percent on the first $97,500 (for 2007) of wages paid to such an employee. See IRC §§ 3101(a) (setting rate for employee), 3111(a) (setting rate for employer), 3121(a)(1) (limiting tax base to $97,500 of wages by reference to social security "contribution and benefit base"); 42 USC § 430 (2000) (determining "contribution and benefit base"). The second tax on "wages" is for purposes of providing hospital insurance to the aged and disabled (commonly referred to as "Medicare"). It is imposed once on the employee and once on the employer, in each case at a rate of 1.45 percent on all wages without limit. IRC §§ 3101(b) (specifying rate for employee), 3111(b) (specifying rate for employer). Sections 3301-11 of the Internal Revenue Code impose an additional unemployment tax upon employers only. The tax is 6.2 percent of the wages paid to each employee up to a wage limit of $7,000. IRC §§ 3301(a) (setting rate), 3306(b)(1) (limiting tax base to $7,000 of wages). In calculating her income tax, the employer takes an "above-the-line" deduction for her share of the three aforementioned taxes paid with respect to each employee. IRC §§ 164(a) (allowing deduction), 62(a)(1) (allowing deduction above the line).To varying extents, according to a complex set of rules, and subject to congressional will, the individual's payment of these taxes is tied to her receipt of specific government benefits under the corresponding benefit programs.
186. Sections 1401-03 of the Internal Revenue Code impose two taxes on "self-employment income," which consists roughly of the nonportfolio trade or business income of sole proprietors and (nonlimited) partners. IRC § 1402 (defining "self-employment income"), 1402(a)(1)-(3) (excluding portfolio income), 1402(a)(13) (excluding earnings of limited partners). The first tax is for purposes of providing old-age, survivors, and disability insurance (commonly referred to as "social security"). This tax is imposed at a rate of 12.4 percent on the first $97,500 (for 2007) of self-employment income. IRC §§ 1401(a) (specifying rate), 1402(b)(1) (limiting base to $97,500 via reference to the social security "contribution and benefit base"); 42 USC § 430 (determining "contribution and benefit base"). The second tax is for purposes of providing hospital insurance to the aged and disabled (commonly referred to as "Medicare"). It is imposed at a rate of 2.9 percent on all "self-employment income." IRC §1401(b). In calculating "self-employment income" for purposes of applying either of these taxes, the taxpayer does not take the income tax deduction under IRC §1 64(f), as described in the next sentence, but rather deducts one half of what his total tax liability summed across the two taxes would be were "self-employment income" determined in the absence of any deduction for such self-employment tax payment. IRC § 1402(a)(12). In calculating her income tax, the individual takes an above-the-line deduction for one half of her self-employment tax liability. IRC §§ 164(f)(1) (specifying deduction amount), 164(f)(2) (treating deduction as nonemployee trade or business expense), 62(a)(1) (allowing above-the-line deduction for nonemployee trade or business expense). To varying extents, according to a complex set of rules, and subject to congressional will, the individual's payment of these taxes is tied to her receipt of specific government benefits under the corresponding insurance programs.
187. IRC § 1402(a) (defining "self-employment income," the tax base for the self-employment tax and specifically treating a partner's distributive share of partnership income or loss). As this section indicates, if the returns to the general partner's service provision via her profits interest came in the form of pass-through partnership income, rather than partnership liquidation, the general partner might owe self-employment tax on this amount depending on the character of such income. Partners owe self-employment tax on pass-through partnership income, but not income from the sale or exchange of capital assets or real or depreciable property used in a trade or business, or dividends, interest, or rents.
188. See notes 132-33.
189. Fleischer, 83 NYU L Rev (forthcoming 2008) (cited in note 6): One largely overlooked anomaly in the system is the treatment of sweat equity. Sweat equity, as I define it here, is the ability to invest with pre-tax dollars in one's own business. Sweat equity is more lightly taxed than other forms of labor income. . . . [T]he subsidy . . . does not stem only from the capital gains preference. Rather, it comes from the choice we make not to tax the imputed income that accompanies working for oneself-the ability to invest with pre-tax dollars. The model just described breaks down in two ways, however, revealing the subsidy for entrepreneurship. The first is in the assumption of constant tax rates. . . .The second way the model breaks down . . . is its failure to tax the imputed income that comes from investing in a self-created asset. In more familiar terms, the service partner has the ability to invest in his own business using pre-tax dollars. As we shall see, it is the failure to reach this imputed income that provides much of the subsidy. . . Surprisingly, treating all carried interest allocations as ordinary income does not eliminate the tax advantage associated with a profits interest in a partnership. Specifically, it fails to tax the imputed income from investing labor in one's own business using pre-tax dollars. See also Ordower, 7 UC Davis Bus L J at 361 (cited in note 1) ("Rather than investing in a partnership with assets or money that had been taxed before the partner used that capital to invest in the partnership, as other partners do, partners who received only profits interests for services invest with untaxed service income. A change in the rule makes sense.").
190. Rev Rul 60-31, 1960-1 Cum Bull 174 (giving tax effect to certain deferred compensation plans). See also Daniel Halperin and Ethan Yale, Deferred Compensation Revisited 6-7 (George-town University Law Center, Business, Economics, and Regulatory Policy Working Paper Series Research Paper No 969074, Feb 2007), online at http://ssrn.com/abstract=%9058 (visited June 8, 2008) (explaining the taxation of nonqualified deferred compensation).
191. See note 136.
192. Id.
193. IRC § 121 (excluding from income a portion of the gain from the sale of a principal residence).
194. Alternatively, or in addition, we might imagine that the general partner is, at any given time, managing her own prior investment of labor value.
195. Consider, for example, that Fleischer organizes his analysis of the tax benefit into a discussion of deferral and a discussion of conversion, and places his discussion of the supposed imputed income benefit from profits interests in the section on conversion. See Fleischer, 83 NYU L Rev (forthcoming 2008) (cited in note 6).
196. Income shifting is limited in a variety of ways throughout the Code. See, for example, the "kiddie tax" imposed by IRC § 1(g) (taxing certain unearned income of children as if it were the parent's income). In other ways it is permitted, as when spouses with diverse incomes are permitted to file jointly. IRC § 6013 (allowing a husband and wife to jointly file a single return).
197. See Part III.D.
198. Note, in particular, that not all long-term capital gains are taxed at 15 percent IRC § 1(h) (prescribing different tax rates for long-term capital gains, ranging from 0 percent to 28 percent).
199. Treasury Report at 28 n 95 (cited in note 1) (stating that approximately 20 percent of funds invested in private equity come from endowments and approximately 30 percent come from pension funds). See also Private Equity Council, Press Release, Raising Taxes on Private Equity Investments Could Hurt U.S. Companies and Competitiveness, PEC Tells Congress (cited in note 15) ("Private equity investment firms between 1991 and 2006 returned more than $430 billion in profits to their investors, nearly half of which are public and private pension funds, university endowments and charitable foundations, [PEC Board Chairman Bruce Rosenblum] said.").
200. Note that the existence of partners who are themselves C corporations may force the partnership to adopt the accrual method of tax accounting. IRC § 448 (describing this limitation on the use of cash method of accounting).
201. IRC § 11(b). The marginal rate for corporations is 39 percent for taxable incomes between $ 100,000 and $335,000 and 38 percent for taxable incomes between $15,000,000 and $18,333,333.
202. IRC §§ 1(h) (providing preferential treatment for long-term capital gains and dividends), 1(a) (effectively restricting application of § 1(h) to individuals), 11 (imposing tax on taxable income of corporations and providing for no capital gains rate preference).
203. Note that, to the limited partner's shareholders, the tax consequence of the fact that the limited partner is organized and separately taxed as a corporation is orthogonal to a comparison of the imputed salary and cash salary reinvestment plans.
204. IRC § 1014 ("Basis of property acquired from a decedent."). This basis step-up is scheduled to be eliminated in 2010. Economic Growth and Tax Relief Reconciliation Act, 115 Stat at 38. However, the provisions of this act "sunset" on December 31, 2010, see id § 901, 115 Stat at 150 (general sunset provision for act), and the step-up will thus be automatically reinstated in 2011, unless Congress makes the change permanent.
205. Note that the estate tax is irrelevant to the comparison of compensatory plans because the estate tax applies to both plans in the same way.
206. IRC § 1212(b)(1).
207. See Part II.B for a discussion of potentially applicable limitations
208. IRC § 469(b) (governing disallowed loss or credit carried to next year), 469(g) (prescribing dispositions of the entire interest in passive activity).
209. This timing swap should be distinguished from the joint deferral caused by adopting an imputed salary plan when the limited partner's deduction would be suspended. The latter was analyzed in Part U.C.
210. Otherwise, the compensation would be treated as "constructively received" in year one. Treas Reg §1.451-1 (describing the general rule for taxable year of inclusion); Treas Reg § 1.451-2 (governing constructive receipt of income).
211. Otherwise, the right to future compensation might be deemed a cash equivalent and currently taxed. See Rev Rul 60-31, 1960-1 Cum Bull 174 (explaining the general rule for the taxable year of inclusion).
212. IRC § 404(a)(5): [I]f compensation is paid or accrued on account of any employee . . . [it] shall be deductible under this section . . . if the plan is not one included in paragraph (1), (2), or (3), in the taxable year in which an amount attributable to the contribution is includible in the gross income of employees participating in the plan.
213. See Halperin and Yale, Deferred Compensation at 4-7 (cited in note 137) (explaining how § 409A limited taxpayer flexibility by preventing, among other things, "some do-it-yourself income averaging"). The application of § 409A to profits interests is unsettled. See generally Notice 2005-1, 2005-2 Int Rev Bull 274, 279 ("[Section] 409A may apply to arrangements between a partner and a partnership which provides for the deferral of compensation under a nonqualified deferred compensation plan. However, until additional guidance is issued, for purposes of § 409A taxpayers may treat the issuance of a partnership interest (including a profits interest), or an option to purchase a partnership interest, granted in connection with the performance of services under the same principles that govern the issuance of stock.").
214. See, for example, Carried Interest Part II Hearings (cited in note 5) (testimony of William D. Stanfill, Founding Partner, Trailhead Ventures, LP) ("Our [private equity fund's] limited partners include state and corporate retirement funds, university endowments, and the occasional high net worth individual.").
215. IRC § 511 et seq (imposing unrelated business income tax). See notes 16 and 101 for a discussion of unrelated business income tax in the private equity context.
216. Edward Hayes, SEC Turns Attention to Hedge Fund Side Letters, CCH Wall Street (June 9,2006), online at http://www1.cchwallstreet.com/ws-portal/ content/news/container.jsp?fn=06-19-06 (visited June 8,2008) (describing how hedge funds often provide different terms to different investors through the use of individualized agreements called "side letters");
217. Ordower, 7 UC Davis Bus L J at 346 (cited in note 1) ("In order to avoid confrontation with the bulk of the fund's investors, hedge fund managers tend to contract separately for such fee arrangements and do not disclose their details to other investors"); Carried Interest Part III Hearings (cited in note 5) (written testimony of Russell Read, Chief Investment Officer, California Public Employees' Retirement System) (emphasizing the negotiated and variable terms of private equity partnership agreements).
218. This is shown formally in a web appendix, online at www.cstone.net/ ~csanchir/SanchiricoPrivate-Equity-Web-Appendix-082307.pdf (visited June 8,2008) (cited in note 27).
219. See id.
220. See note 163.
221. This Part develops and extends the ideas in Chris William Sanchirico, Taxing Carry: The Problematic Analogy to "Sweat Equity," 117 Tax Notes 239 (2007), which was first circulated and posted on SSRN on September 20, 2007.
222. See, for example, note 17.
223. Self-created goodwill is treated as a capital asset and is thereby taxed at preferential capital gains rates. IRC § 1221(a) (defining "capital asset"). See generally IRS Private Letter Ruling No 200243002 (2002) (describing the statutory, judicial, and regulatory authority under which self-created goodwill qualifies as a "capital asset"). Purchased goodwill is not generally treated as a capital asset per se. But if it is used in a trade or business and held for more than one year, it is taxed at the same preferential rate, except to the extent previously amortized or depreciated. IRC §§ 1231 (allowing long-term capital gains treatment for property used in the trade or business that is regarded as depreciable under § 167), 197(a) (allowing deduction for amortization of acquired goodwill), 197(f)(7) (prescribing that acquired goodwill generally be regarded as property depreciable under § 167), 1245(a)(2)(A) (requiring ordinary income treatment for gain on property that is regarded as used in a trade or business and depreciable under § 167 to the extent that such gain is attributable to deductions for amortization).
224. Weisbach, 94 Va L Rev (forthcoming 2008) (cited in note 6) ("[E]ntrepreneurs such as founders of companies get capital gains when they sell their shares even if the gains are attributable to labor income. . . . [P]erhaps the best thing we can say is that this approach is built deeply into the structure of current law. Any change in the treatment of a private equity sponsor engaged directly in their investment activity would require reexamination of these basic principles.") (emphasis added).
225. This Part has benefited enormously from discussions with Michael Knoll, who among other things suggested, in connection with an earlier draft, that the capitalization of labor costs was an important question for discussion.
226. Treas Reg § 1.263(a)4(b)(1)(iii) (requiring capitalization of the cost of creating or enhancing a "separate and distinct intangible asset"); Treas Reg § 1.263(a)4(b)(3)(i) (defining "separate and distinct intangible asset"). For more on this issue, see notes 80-81.
227. Despite its specific holding that the taxpayer book publisher had to capitalize the cost of outsourced book production, the court in Encyclopaedia Britannica, Inc v Commissioner of Internal Revenue, 685 F2d 212, 217 (7th Cir 1982), expresses a similar sentiment, as quoted in note 75.
228. IRC §§ 263 (disallowing deductions for certain capital expenditures), 263A (specifically requiring capitalization of the cost of producing or acquiring inventory or producing noninventory real or tangible assets used in a trade or business or other income producing activity).
229. See IRC §§ 167 (allowing a deduction for depreciation of certain business or incomeproducing assets), 168 (determining the magnitude of the § 167 depreciation deduction for certain tangible property), 197 (allowing an amortization deduction for certain business or incomeproducing intangibles), 263A (requiring capitalization of inventory costs and the cost of producing real or tangible property used in a trade or business or income producing activity), 61(a)(2) (including "gross income derived from business" in the definition of gross income); Treas Reg 1.61-3(a) (allowing the subtraction of "cost of goods sold" from revenues in determining "gross income derived from business" under § 61(a)(2)). Note that depreciation and amortization deductions in excess of certain assets' true decline in value may be "recaptured" upon sale or disposition under § 1245 and partly under § 1250. See also IRC §§ 1245 (requiring ordinary income treatment of gains from disposition of certain depreciable property to the extent of depreciation deductions previously taken), 1250 (providing a similar, but more limited recapture rule for certain depreciable realty). Note also, by way of comparison, that self-created goodwill is generally not amortizable. IRC § 197; Treas Reg 1.167(a)-3.
230. The sole owner of a limited liability company can elect to be treated as a sole proprietor for tax purposes. The fund manager in this example can also be thought of as the sole shareholder of an S corporation, a pass-through entity for tax purposes. IRC §§ 1361-63, 1366-68, 1371-75, 1377-79 (governing tax treatment of "S Corporations" and their shareholders).
231. In this fund-manager-as-owner scenario, we can specifically think of this $6 million as attributable to business assets-such as goodwill or the undepreciated cost of real or depreciable property used in the business-the gains from which would be taxed at long-term capital gains rates upon the sale of the business. IRC §§ 1221(a) (defining "capital asset"), 1231 (allowing long-term capital gains treatment for property used in the trade or business that is regarded as depreciable under § 167), 1245 (requiring ordinary income treatment of gains from disposition of certain depreciable property to the extent of depreciation deductions previously taken), 1250 (providing a similar, but more limited recapture rule for certain depreciable realty).
232. Recall that we stipulate that any cash salary payment be reinvested in the enterprise so that the explicit salary scenario is economically equivalent to the imputed salary scenario, and we can thereby be confident that any differences in after-tax proceeds are derived solely from differences in tax treatment.
233. A sole proprietor's basis in her business is distributed among the assets of the business. For concreteness, one can imagine that this is allocated to IRC § 1231 property. See IRC § 1231 (requiring ordinary income treatment of gains from disposition of certain depreciable property to the extent of depreciation deductions previously taken). What is important is that $1 million is the aggregate basis that is, effectively, subtracted from the aggregate amount realized in order to, effectively, calculate aggregate capital gains.
234. Six million dollars is the "amount realized," and from this is subtracted a $1 million basis.
235. This note considers the investment interest limitation in IRC § 163(d). We shall assume that the manager/owner is either deemed to use the loan principal in a trade or business in which she materially participates, IRC § 163(d)(5)(A) (defining "property held for investment"), or has sufficient "net investment income," as defined in IRC § 163(d)(4), from other sources. In either event, the investment interest limitation in IRC § 163(d) would not affect the deductibility of this interest expense. If it were applicable, the investment interest limitation would prevent the manager/owner from taking an ordinary income deduction for interest used to finance capital gains income. Instead, the manager would have two choices. First, she could take an ordinary deduction for the interest, but then she would have to take as much of the capital gain as ordinary income. IRC §§ 163(d)(4)(b)(iii) (allowing taxpayer to elect to count net capital gain as "investment income"), 1(h)(2) (eliminating capital gains tax preference for net capital gain elected under § 163(d)(4)(b)(iii)). Second, she could carry forward the interest deduction and deduct "net investment income" again in future years. IRC § 163(d)(2).
236. IRC §§ 61 (defining "gross income"), 1221 (defining "capital asset").
237. See note 179.
238. Further adding to the confusion is the fact that the sole owner of an S corporation, which is treated similarly for tax purposes, could pay herself deductible salary. See, for example, Deborah H. Schenk, Federal Taxation of S Corporations § 10.02[1] (Law Journal Press 2007) ("The corporation is permitted to take a deduction for reasonable compensation or salary paid to employees. . . . [I]n the case of an employee-shareholder, the tax results are almost always the same whether the amount received is salary or a distribution.").
239. Of course, employees have some leeway in deferring compensation. See, for example, the discussion of nonqualified deferred compensation in Part II.C.
240. Assume for now that the owner can take the deduction.
241. See note 179.
242. This claim has been made by policymakers and tax scholars. See note 21.
243. But see the discussion in Part V.C regarding the incidence of this tax benefit.
244. See generally Louis Kaplow, Horizontal Equity: Measures in Search of a Principle, 42 Natl Tax J 139 (1989) (questioning the justification for horizontal equity as an independent welfare principle);
245. Richard A. Musgrave, Horizontal Equity, Once More, 43 Natl Tax J 113 (1990) (arguing for horizontal equity as an independent welfare principle);
246. Louis Kaplow, Commentary on Tax Policy and Horizontal Equity, in Kevin A. Hassett and R. Glenn Hubbard, eds, Inequality and Tax Policy 75 (American Enterprise Institute 2001) (critiquing Auerbach and Hassett and further arguing that horizontal equity is unjustified as an independent principle);
247. Alan J. Auerbach and Kevin A. Hassett, A New Measure of Horizontal Equity, 92 Am Econ Rev 1116 (2002) (deriving a measure of inequality that is "decomposable into components that are naturally interpreted as horizontal and vertical equity").
248. Whether inequality increases or decreases depends on the precise structure of the problem and the precise manner in which inequality is measured. A web appendix, online at www.cstone.net/~csanchir/Sanchirico-Private-Equity- Web-Appendix-082307 .pdf (visited June 8, 2008) (cited in note 27), shows that inequality can decrease in a simple example under similar circumstances.
249. This response is related to the arguments for a consumption tax-and even more so, the arguments for an endowment tax-as summarized in Daniel Shaviro, Beyond the Proconsumption Tax Consensus, 60 Stan L Rev 745 (2007). The assertion, more precisely stated, is that we should strive to tax the present discounted value of individuals' lifetime endowments, and that taxing the return to savings (for example via taxing capital gains) moves us away from this ideal. As Daniel Shaviro notes, however, taxing "once"- more precisely taxing only the present discounted value of endowment value-may not be the optimal tax structure when other factors, like incomplete financial markets and incomplete information regarding individual endowments, are taken into account. Id at 770-80.
250. The importance of the latter factor is analyzed at length in Chris William Sanchirico, Deconstructing the New Efficiency Rationale, 86 Cornell L Rev 1003 (2001).
251. See Laurence J. Kotlikoff and Lawrence H. Summers, The Role of Intergenerational Transfers in Aggregate Capital Accumulation, 89 J Polit Econ 706, 730 (1981) ("Intergenerational transfers appear to be the major element determining wealth accumulation in the United States.").
252. Compare Franco Modigliani, The Role of Intergenerational Transfers and Life Cycle Saving in the Accumulation of Wealth, 2 J Econ Perspectives 15, 18-21 (1988)
253. (critiquing Kotlikoff and Summers), with Laurence J. Kotlikoff, Intergenerational Transfers and Savings, 2 J Econ Perspectives 41, 43 (1988)
254. (responding to Modigliani), and William G. Gale and John Karl Scholz, Intergenerational Transfers and the Accumulation of Wealth, 8 J Econ Perspectives 145, 156-57 (1994) (finding evidence consistent with Kotlikoff and Summer's original results).
255. IRC § 102 (governing gifts and inheritances and excluding such from gross income).
256. IRC § 2010(c) (allowing a credit against estate tax equal to the amount obtained by applying the tax rate tables to $2 million, in 2007 and 2008, and $3.5 million in 2009). The estate tax is scheduled to be completely eliminated in 2010. Economic Growth and Tax Relief Reconciliation Act, 115 Stat at 38. However, the provisions of this Act eliminating the estate tax "sunset" on December 31,2010, see id § 901, 115 Stat at 150 (general sunset provision for act), and the estate tax will thus be automatically reinstated in 2011, unless Congress makes the repeal permanent. Regarding the gift tax, which is scheduled to survive potential repeal of the estate tax, see IRC § 2505(a) (allowing a credit against gift tax liability in any year equal to the amount obtained by applying the tax rate table to $1 million and then subtracting the portion of such amount that could be taken as a credit in prior years). See also IRC §2503(b) (excluding from the definition "taxable gifts" for any given year $12,000 (for 2007) per spouse of gifts made to any person during such taxable year).
257. One might claim that the investor's donor/bequeather had already been taxed when this donor/bequeather earned the money. Whether this counts as taxation to the investor herself is an issue subject to intense controversy.
258. Laura E. Cunningham and Noël B. Cunningham, The Logic of Subchapter K: A Conceptual Guide to the Taxation of Partnerships 134 n 22 (West 3d ed 2006) ("[T]he receipt of a profits interest in exchange for services has been a contentious issue for 35 years.").
259. See, for example, Fleischer, 83 NYU L Rev (forthcoming 2008) (cited in note 6) ("Almost nine times as many Wall Street managers earned over $100 million as public company CEOs; many of these top-earners on Wall Street are fund managers.").
260. David D. Kirkpatrick, Romney's Fortunes Tied to Business Riches, NY Times Al (June 4, 2007) ("Mr. [Mitt] Romney [ ] persuaded investors to let the Bain partners keep 30 percent of the profits-an arrangement that is still rare.").
261. Anderson and Sorkin, Congress Weighs End to Tax Break for Hedge Funds, NY Times at Al (cited in note 7) ("This tax break has helped add to the record level of wealth among hedge fund managers. . . Private equity executives alone took home more than $45 billion in pay in the past six years.").
262. See the sources cited in note 1.
263. See, for example, SEC Report at 76-88 (cited in note 1) (reviewing the operations and practices of hedge funds and the regulatory concerns addressing them); Role of Hedge Funds in our Capital Markets, Hearings before the Subcommittee on Securities, Insurance, and Investment of the Senate Committee on Banking, Housing, and Urban Affairs, 109th Cong, 2nd Sess (May 16,2006), online at http://banking.senate.gov/public/index.cfm?Fuseaction=Hearings.Detail& HearingID=40b5e58b-b4484a8a-8bb6-63d314289b8d (visited June 8, 2008) (same); Regulation of Hedge Funds, Hearings before the Subcommitee on Securities, Insurance, and Investment of the Senate Committee on Banking, Housing, and Urban Affairs, 109th Cong, 2nd Sess (July 25, 2006), online at http://banking.senate. gov/pubhc/index.cfm?Fuseaction=HearmgsDetail&HearingID= e5cd2741-2416-465a- b3e8-ae27c4bcadb4 (visited June 8,2008) (same).
264. Anderson and Sorkin, Congress Weighs End to Tax Break for Hedge Funds, NY Times at Al (cited in note 7) ("The industry argues that the portion of profits they receive from investments should receive preferential treatment because of the risk involved.").