ABA TAx Section Pronouncement on Carried Interest

by Linda Beale

ABA TAx Section Pronouncement on Carried Interest
originally posted at Ataxingmatter (Nov. 10)

The American Bar Association Section of Taxaction has issued a letter on Comments on Carried Interest Proposals in senate Amendment 4386 to H.R. 4213 (Nov. 5, 2010).

As many are aware, a letter from the officers of the ABA Tax  Section is one that has been developed by a relatively small group of participants and submitted to the council of officers for approval.  Most members have little opportunity, if any, to comment on the statement, though one can assume that in many cases the statements are likely to represent the views of a majority of the membership.  The leadership is not likely to step lightly into territory that they do not think would be supported by a majority of the membership.

This letter went to the current chairs and ranking members of the House Ways & Means Committee and the Senate Finance Committee, with copies to staff directors as well as the Chief of Staff for the Joint Committee on Taxation.

The letter makes  recommendations about the proposed statute, which would apply to service partners in investment service partnerships to characterize income allocations as ordinary compensation income and defer losses, and impose self-employment tax on the service partner interests in such partnerships.

Preliminarily, it reiterates a position stated in prior comments that taxation of carried interest adds “burdensome complexities” and “alters fundamental principles of partnership taxation” and should therefore be reconsidered. Not a surprising position for tax lawyers.  We are in most cases as self-interested as the next guy or gal.  This provision would result in increased taxes for fund managers in partnerships that have claimed a significant rate and deferral preference for their income from services compared to the ordinary treatment of wages paid for services to less advantaged workers.  And of course there is a good bit of work for tax lawyers developing partnership agreements and doing adquisition and other tax work for private equity funds and other investment partnerships that have taken advantage of this “loophole” to create significant wealth for these managers. These service partners may earn this kind of compensation in the hundreds of millions of dollars annually.  It is very big business.

Nonetheless, there is an essential fairness issue at stake.  If you are relatively rich and a part of the financial institution world of investment partnerships, you can earn a very very good “salary” for your work but get deferral advantages compared to ordinary workers and preferential rate treatment, paying much less in income taxes than ordinary workers.  It is hard to see how, in conscience, Congress can avoid enacting a carried interest provision that will undo that unfair advantage.  And since it will likely raise revenues in an era of much complaint about deficits and debt ceilings, what’s not to like?

Secondly, the letter suggests that, if a carried interest provision is nonetheless to be adopted, the proposed statutory language is inadequate to the task.  It urges modifications to the scope of the proposal and to the treatment of qualified capital interests. Among other things, as to scope

• the letter claims that the proposal does more than tax the compensation element as ordinary income, because of the application of loss deferral and manadatory gain recognition for C corporations.  Yes, the proposal does do more than just deal with the rate issue, since it also addresses deferal and required gain recognition.  Why is that inappropriate?  The letter doesn’t say.
• The letter includes in the “scope” discussion the recommendation that “small businesses” be exempted from the provision because of the purported burden of compliance.  This is similar to the attack on many other business tax provisions–the argument that “small businesses” should be exempt because it is too complex for them.  But that is questionable here.  Businesses that use the service partner loophole already have been dealing with complex partnership allocation and distribution provisions.  This proposal has been gathering steam for some time, so that they should be prepared to deal with it.  They are well aware of the preferential treatment that the partnership arrangement currently provides and quite likely chose partnership form in order to get that treatment (among other advantages), despite the complexity.  They generally will have a firm that handles the tax matters for the partnership anyway, so this does not really add to the burden on the business.  This has the appearance of a red herring argument–as it usually is  when “you should eliminate the tax because the burden of compliance is too much” arguments are used against everything from the estate tax to the demand for 100% expensing. 
• the letter criticizes the provision that treats all tiered partnerships as “bad” assets for these purposes.  It suggests instead a look-through approach.  There may be merit in that though there is a trade-off in the increased complexity due to the look-through rules.  Again, note that when it is to get a benefit for taxpayers, proponents tend to disregard the added complexity…
• the letter argues for a provision to end the service partnership taint if the interest ceases to be an investment service partnership interest.   Taints often carry over to ensure appropriate treatment of income over the long term, but it is possible that a cut-off provision would be appropriate.  But again, there is a trade-off in complexity and lack of information about the circumstances in which interests would change into and out of investment service partnership interests.  Without such information, it might be better to stick with the bright-line taint rule.

As to “qualified capital interests”, the letter urges a much broader view of qualified capital (amounts as to which allocations will not be treated as compensation income).  For example, it includes the following recommendations (among others):

• The letter urges that a partner who purchases an interest from an existing partner be allowed to treat the purchase price for the interest as qualified capital, rather than merely acceding to the amount of the qualified capital account of the transferor partner.  Note that the norm for capital accounts for purchased interests is that a purchasing partner takes the transferor partner’s capital account.  It is not clear why the ABA believes that the additional complexity a purchase-price-capital account determination would make would be reasonable, nor why purchase price should “count” as qualified capital when the transferor partner had a more limited qualified capital account.  Remember that purchasers of interests from interest holders do not add capital to the enterprise–they are merely putting money in the pocket of the interest holder that, presumably at least, the interest holder would eventually have received from the partnership. 
• The letter argues against the treatment of qualified capital as limited to the original capital contribution if the partnership will make disproportionate allocations of income to original service partners once investors join the partnership.  In other words, under the proposed statute, the capital bookup for appreciation in real estate property held by the partnership and allocable to the service partner during startup is not treated as qualified capital when the investors join, but the letter proposes that it should be.   The letter argues that “the value in a partnership at any such time is economically indistinguishable from value held outside the partnership that a partner could contribute in exchange for qualified capital.”  Doesn’t that miss the point?  If the original partners contribute equally but one provides all of the services for the real estate purchased with that original contribution, then surely the increase in value allocable to the service partner is attributable to the services provided as well as capital.  Tax rules often take an “all or nothing” stance, accomplishing with “rough justice” what would otherwise require intricate bifurcation rules or rough injustice results (here, that none of the increment in value to the service partner would be treated as payable for the services of the service partner).  The fact that a purchased item worth 250 would be “economically indistinguishable” from a purchased item originally worth 100 that has increased to 250 with services from the purchaser misses the point of attempting to account for the compensation received by the servicer the way we account for compensation of others.  And note that the letter’s recommended position would result in a significant long-term advantage, in that much more of the “disproportionate allocations” that the service partner will receive henceforward would be attributed to qualified capital rather than payment for services.
• the letter also objects to the inconsistent application of section 752, the rule relating to the treatment of increases and decreases in liabilities, which are viewed (outside of this new statute) as contributions and distributions, respectively.  The proposed provision does not treat increases in the service partner’s share of partnership liabilities as a contribution of money to the partnership (created increases in qualified capital), but does treat decreases in a partner’s share of partnership liabilities as distributions out of capital, thus reducing the qualified capital account.  The statutory inconsistency reflects many other anti-abuse rules in the Code, such as the ones that disallow loss recognition but permit gain recognition.  While consistency is generally preferable, the ABA tax section should have provided some discussion of the likely rationale for not treating increased liability responsibility as a contribution of qualified capital in these cases, rather than merely arguning for consistency for consistency’s sake.

The letter ends with a restatement of concern about increasing complexity