Romney's Returns: What is Carried Interest

Now that we know that Mittens will be releasing his tax return on Tuesday, I thought it would be an opportune moment to revisit a diary I wrote awhile ago (under my former user ID burrow owl).  Below is an edited version of that diary, going through the tax and the underlying economics of the carried interest.  I follow with a brief discussion of the clues I'll be looking for in order to figure out what sorts of structures that Bain Capital has deployed, which in turn should tell us whether the offshores that Mittens is invested in have reduced his tax bill below what it would have been had he invested in an onshore entity.

   

           

Structure & Taxation of Carried Interest

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 income¹, 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").  Importantly, in order for Mittens to get the benefit of the lower rates, his carried interest must be structured as a partnership interest; in essence, one is able to either defer income or get the benefit of lower rates, but one can't get both.  For Mittens, where his investments throw off so much long term cap gains, it's a no-brainer to opt for lower rates instead of deferral.

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).

Put more simply: under current tax law, the carried interest is worth zero when it's granted to the manager.  This is, of course, patently insane.  If I offered a buck to Mittens for his carried interest, he'd laugh.  If it were actually worth zero, though, he'd take the offer.  Note, though: the conceptual issue w/ the carried interest is a valuation problem.²

What to Look for in Mittens's Tax Returns

The big question re: Mittens's taxes is whether he's using offshores in order to avoid tax.  My working hypothesis is that his carried interest is running through the offshore partnerships.  As noted above, in order for that to retain the lower rate treatment, the offshores have to have elected to be treated as U.S. partnerships.  IOW, as far as the IRS is concerned they're U.S. partnerships, and Mittens gets no special tax benefit from the offshore situs.  That's a testable hypothesis: if we see anything other than non-passive ordinary income from these entities, then we know they've elected to be treated as US partnerships and that Mittens isn't engaging in any crafty tax planning to cheat Uncle Sam (well, apart from carried interest treatment generally, that is).  If, on the other hand, some of the offshores don't show up anywhere, there's a good chance that that means it's part of his IRA or is a management company (discussed below).  When tax exempt entities (encompassing charities, pensions, IRAs, and 401(k)s) invest in private equity, they almost always do so via offshores in order to avoid the unrelated business income tax, which is a tax charities have to pay on certain classes of income.  One of these classes is "debt-financed income."  Since private equity funds typically use a lot of leverage, and since leverage is debt, these funds typically throw off a lot of income that's taxable to charities and the like.  By investing in an offshore that elects to be treated as a corporation, the taxable income is converted into non-taxable dividend income.  

A second component of private equity income is the management fee (this is the "2" in "2 and 20": the investors pay the manager of the fund 2% of the assets in the fund).  Because the management fee is a fee for service, it's always ordinary income.  Unlike w/ carried interest, then, there's no benefit to having it flow through a partnership.  Since you can have either deferral or lower rates, then, people have always opted for deferral when it comes to the management fee.  Prior to the passage of Section 457A in 2008, which put a stop to these shenanigans, the management fee would be structured as follows: the partnership accrues the 2% fee and owes them to an offshore corporation owned by the fund manager, and then puts the funds aside.  If the funds were actually paid to the company, then the tax code's anti-abuse provisions (specifically, the CFC rules) would kick in and force the manager to pay tax immediately on the accrued income.  The catch, though, is that the offshore corp elects a "cash basis" of accounting, meaning that it doesn't recognize income until it's received.  So it's a clever asymmetry: the partnership recognizes the expense in year 1, but the manager doesn't recognize the income until it's actually received.  The upshot is that the fund manager can defer the taxable event until the partnership actually pays the funds over.  As noted, the passage of section 457A put the kibosh on that scheme, but relevant for these purposes is that offshore management companies that were set up prior to 2008 can continue to defer income until 2018.  

So: if Mittens is getting exclusively nonpassive ordinary income (or isn't getting any income) from a given offshore, there's a decent chance that it's one of these management companies, which exist solely to defer taxable income.  

So that's what I'll be combing the returns for: if a fund has a diversity of income, it's a partnership and we can infer that no shenanigans (again, apart from the carried interest itself) have been engaged in.  If, OTOH, there's nonpassive income and nothing else from an offshore, then it could be a tax-deferral vehicle that would be a great campaign issue.  Here's to hoping the income is described as "management fee," but we probably won't get that lucky.

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.

² 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.