Now that the Senate has passed its own version of the tax extenders bill1 , there's been quite a bit of buzz lately about the taxation of the carried interest. Below the fold, I'll touch briefly on the structure and history of the carried interest and the proposed fix.
Structure & Taxation
The carried interest is the incentive fee that hedge fund and private equity fund managers earn on their performance. A common set-up provides that the fund manager is entitled to 20% of all the profits that the fund makes for the investors (the "incentive fee"). So, if I run a fund and make $100 in investment income for the investors on a $500 investment, I earn $20, and the remaining $80 goes to the investors. There's typically something called a hurdle rate: I'll only be entitled to the incentive fee if I make more than some predetermined rate of return for the investors. To return to the example: if the hurdle rate is 10% a year, then I'm entitled to 20% of the excess of 10%, or (100 - (500 x 10%)) x 20% = $10. When the hurdle rate is modest and the profits large, that's a whole lot of money.
How is the carried interest taxed? The common formulation is that it's taxed at "the capital gains rate of 15%;" at best, that is a truthy statement. The carried interest is an interest in a partnership, and is taxed as partnership income. Partnerships, for tax purposes, are "pass through entities": whatever income they make is passed through to the partners and retains the same character in the hands of the partners as had in the partnership. And, unlike a corporation where income is recognized only when received by the owner in the form of a dividend, partners recognize taxable income in the year that the partnership receives it. To return to the example above: if 50% of the income I make for the fund is short-term capital gain (taxed at 35%) and 50% is long-term capital gain (taxed at 15%), my tax return will report $5 of short-term cap gain and $5 of long-term cap gain and my tax will be ($5 x 35%) + ($5 x 15%) = $2.50, for an effective rate of 25%. Depending on the type of fund, effective rates will vary quite a bit. Hedge funds that move in and out of positions quickly will have substantial 35% rate income2, while private equity funds - whose raison d'etre is buying and holding whole companies - will have the supermajority of its income as 15% long-term capital gain (whence the truthy notion that fund managers are taxed at the "15% capital gains rate").
Tax History
In the early '60s, Sol Diamond, a mortgage broker, was approached by Philip Kargman with a proposal. Kargman had purchased a right of first refusal on an office payment, and needed to find financing for the closing. Diamond agreed to secure financing in exchange for 60% of the profits from the project; a few weeks after successfully arranging a loan, Diamond sold his profits interest to another investor for $40,000. He claimed the sale as a capital gain, and the IRS disagreed on audit, arguing that the receipt of the profits interest was ordinary income that could be valued by reference to the sale. Per the IRS, the sequence is as follows: Diamond received a profits interest worth $40k (because it is property received in exchange for service, it is ordinary income), then sells it for $40k producing a net capital gain of $0 (having "purchased" the interest with $40k ordinary income, Diamond's basis in the property is $40k, so there is no gain on the sale). The 7th Circuit ultimately agreed with the IRS. Somewhat ominously, however, the court also noted with respect to legal scholars:
There is a startling degree of unanimity that the conferral of a profit-share as compensation for services is not income at the time of the conferral, although little by way of explanation of why this should be so, or analysis of statute or regulation to show that it is prescribed.
This unanimity subsequently convinced the 8th Circuit in Campbell v. Commissioner. The Diamond court made two assertions in the case: (1) the receipt of a profits interest is a taxable event (eg, I get income when I get the profits interest); and (2) because of the sale that occurred shortly after the receipt of the profits interest, the value of the interest was readily ascertainable. The Campbell court clearly disagrees with (1), but ultimately rests its disagreement on (2):
The partnerships were taking untested positions in regard to deductions and all of them were likely to be challenged and disallowed by the IRS. In fact, many of the deductions were ultimately disallowed. Further, the predictions contained in the offering memoranda were just that — predictions. The partnerships had no track record. Any predictions as to the ultimate success of the operations were speculative. Thus, we hold that Campbell's profits interests in Phillips House, The Grand and Airport were without fair market value at the time he received them and should not have been included in his income for the years in issue.
Or: the partnership may make a profit and may not; at the time of transfer there's no way of knowing whether it will and accordingly no way to value the interest.3 The IRS subsequently acquiesced and released Revenue Procedure 93-27. Trying to harmonize Diamond and Campbell, the IRS averred that it would treat receipt of carried interest as a non-taxable event provided the interest wasn't sold in 2 years and didn't produce a predictable, steady income stream (either of which would render irrelevant the Campbell court's concern about valuation method).
Proposed tax treatment
It's likely that any attempt to close the carried interest loophole will be substantially identical to the version passed by the house in HR 4213. The relevant language:
Section 710
(a) Treatment of distributive share of partnership items.—For purposes of this title, in the case of an investment services partnership interest—
"(1) IN GENERAL.—Notwithstanding section 702(b)—
"(A) any net income with respect to such interest for any partnership taxable year shall be treated as ordinary income, and
"(B) any net loss with respect to such interest for such year, to the extent not disallowed under paragraph (2) for such year, shall be treated as an ordinary loss.
All items of income, gain, deduction, and loss which are taken into account in computing net income or net loss shall be treated as ordinary income or ordinary loss (as the case may be).
Straightforward and elegant. Importantly, the obvious way around this provision is foreclosed by the bill. To convert an ordinary income-producing 20% profits interest to a capital gain-producing capital interest, the fund manager would borrow an amount equivalent to 20% of fund assets and then buy the capital account interest. Smart devils that they are, the House bill provides that income from the partnership will still be ordinary income if the partnership interest was purchased with proceeds of a loan from the partnership or any of its partners.
I'm sure investment funds will rack up a lot of billable hours from law firms trying to find a way around these provisions, but all in all, it's a pretty good bill.
1 The tax code has a number of provisions that aren't permanent features, but are renewed on an annual basis; the most famous - or notorious - example is the "AMT patch" that's passed each year to bump up the threshold for AMT. When originally passed, it wasn't indexed to inflation and so would capture people making less and less each year. Instead of correcting it once by indexing it, the Congress "patches" it each year by increasing the threshold. More important provisions, such as the deductibility of state & local taxes, are passed every few years in these extender bills. I assume that the purpose of cabining these sorts of provisions in sunsetting bills is that the costs of permanent passage don't have to be reflected in budget projections.
2 Some of these funds may even produce an effective rate of over 35%. If all of the income is ordinary income and there are deductions that the taxpayer can't avail themselves of (viz., 2% miscellaneous deductions), then the rate on income, net of expense, can reach into the 40s. That's not very common, but interesting enough to note. Yes, I'm that dorky that I find that interesting.
3 Even assuming no way to value the interest up-front, from an economic standpoint the value of the interest is simply the net present value of the future income accruing to the interest. Since the interest is received for service, it's ordinary income received from the partnership rather than pass-through income from the underlying assets of the partnership. Viewed synchronically, it should be a matter of indifference whether we tax the receipt of the interest upfront as ordinary income or tax all future distributions as ordinary income. In light of that, economics 101 seems to strongly favor the taxation of carried interest as ordinary income.