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Bartlett: Mitt Romney, Carried Interest and Capital Gains

Via  Taxprog blog:

Bartlett: Mitt Romney, Carried Interest and Capital Gains
New York Times:  Mitt Romney, Carried Interest and Capital Gains, by Bruce Bartlett:

A key reason for Mr. Romney’s low tax rate is that a very substantial amount of his income comes from capital gains – 51% in 2011 and 58% in 2010. Capital gains, no matter how large, are taxed at a maximum rate of 15%, whereas wage income can be taxed as much as 35% by the income tax plus taxes for Medicare and Social Security. The latter two are not assessed on capital gains.
The New York Times recently commented in an editorial that while the carried interest loophole is unjustified, the core problem is lower tax rates on capital gains generally. Said The Times, “As long as income from investments is taxed at a lower rate than income from work, there will be no stopping the search for ways, legal or otherwise, to pay the lower rate.”
The view that capital gains should be treated as ordinary income for tax purposes is one that is widely shared by liberal tax reformers. They got their wish, briefly, from 1987 to 1990 because Ronald Reagan agreed to raise the tax rate on capital gains to 28% from 20% in return for a reduction in the top rate on ordinary income to 28% from 50%, as part of the Tax Reform Act of 1986.
There are three big problems, however, with taxing capital gains at the same rate as ordinary income.

First, even if that were the case, capital gains would still be treated more beneficially, because the taxes only apply to realized gains. …
Second, there is a problem with inflation insofar as capital gains are concerned. Many academic studies have shown that a considerable portion of realized capital gains simply represent inflation, rather than real increases in purchasing power. …
Third, it is a fact of life that those with great wealth are the principal beneficiaries of the capital gains tax preference, and they exercise influence in our political system far out of proportion to their numbers. …
[I]t is a pipe dream to believe that eliminating the capital gains preference is the key to fixing the carried interest loophole. It can and should be addressed by treating carried interest as ordinary income, without requiring that all capital gains be taxed as ordinary income.

Romney and Private Equity’s Questionable Schemes for Paying Very Little Tax

by Linda Beale

Romney and Private Equity’s Questionable Schemes for Paying Very Little Tax

Presumably any American who wants to be informed is aware that GOP presidential candidate Mitt Romney‘s claim to business acumen resides in his experience at a private equity firm that made much of its money by ramping up debt at purchased firms and using that debt to repay whatever (usually relatively small) investment the equity firm partners made in what has come to be known as “LBO” deals (for “leveraged buyout”).  In LBOs, the equity firm investors almost always do well to exceedingly well, using mostly other people’s money.

Not so generally for the workers in the bought-out company.  The “rent” profits of the equity firm are often on the back of the workers, who may get fired in favor of outsourcing their jobs or get stuck in a rut, as productivity gains go to the new managers and owners and not to the workers.  At the least, the high debt load makes it very difficult for the company to succeed and certainly difficult for it to give its workers a fair shake.   Remember that one of Romney’s gaffs was to admit that he enjoys firing workers.
Why anybody thinks this kind of winner-take-all, leverage-’em-up mentality of private equity firms suggests the kind of leader desirable for a democracy that purports to provide genuine opportunity for all classes of citizens to live a decent life is beyond me.

But even if the very nature of the business and the common tools of over-leverage and “rent” profits for a very few already at the top don’t give voters cause for pause, then there are the many ways that private equity firm partners manage to avoid paying their fair share of taxes, which ensures that more of the tax burden falls on the less-well-off, that are worthy of consideration, even if candidate Romney has not (as his campaign claims) benefited from them personally.  That is because if Romney is elected president, his views on the acceptability of aggressive tax strategies of questionable legality will matter.  We should know what kinds of tax schemes are routine in the business that he touts as good evidence of his ability to serve as president of this nation–especially if some of them are obviously poor policy (the carried interest treatment) or highly questionable tax avoidance schemes (the management fee conversion waiver scheme).

1. Carried Interest   (More after the jump)

The best known way private equity firm partners reduce taxes is by earning their compensation in the form of “carried interest” and claiming that such profits should be treated the same way a real capital investment in a partnership is treated, even though it is awarded as compensation for their purported management expertise and work and not as a return on an actual investment made.   That is, they claim they are profits partners in the firm and that their compensation is a distribution of the partnership’s profits (usually from gains on sales, and hence eligible for preferential capital gains) to them rather than compensation income.  As such they benefit from the extraordinarily preferential rate for capital gains in the current law as enacted under the Bush administration (generally 15%).  Carried interest is the primary reason that candidate Romney has to pay such a very low rate of taxes on his income from his business.

The Internal Revenue Code (the codification of the federal statutes governing the federal income tax) does not include a specific provision governing profits interests and indicating that such “profits” partners should be treated as actual partners in a partnership (without that partnership interest itself being subject to tax as compensation) entitled to receive capital gains distributions.  Accordingly, as one partnership tax treatise puts it, the tax treatment of a transfer to a “service partner” of a “profits interest” for services “has been uncertain” because “[n]o provision of the Code specifically exempts from taxation the receipt of any partnership interest in exchange for services.”  Willis & Postlewaite, Partnership Taxation, 6th ed, at 4-124.    There is some case law about profits interests, but those cases made it even less clear how and when such interests should be taxed.

Finally, the Service resolved the issue with administrative authority (heavily lobbied for in the interests of equity partners and real estate profit partners, in particular) in Rev. Proc. 93-27 (and later proposed regs and other items) that does not treat the issuance of a compensatory “profits interest” as  a taxable event in most instances.  The main reason for the treatment may well be the so-called “Wall Street Rule”–once incredibly wealthy taxpayers hire sophisticated, high-priced lawyers to produce opinons supportive of a taxpayer-favorable interpretation and then operate as though the Code blesses a particular activity, it is hard for tax administrators to issue regulatory authority that treats that activity differently.

2, Management Fee Conversion Waivers
But there is another lesser-known aspect to the compensation that private equity fund partners earn for their services in their private equity firms–the management fee.  Most explanations describe this as  compensation paid for services that is subject to taxation at the ordinary rate (just like a secretary’s wages would be).  But that disregards a practice that exists among a significant number of equity firms (the Times article linked below says about 40% in 2009) that are willing to take aggressive positions to avoid paying taxes and can afford to pay the tax professionals to provide a way to do it–the management fee waiver conversion scheme.

The conversion of management fees from ordinary income to capital gains is purportedly accomplished by “waiving” the fees (not necessarily across-the-board throughout the life of the firm, but often selectively and on a quarter-by-quarter basis),  Instead of getting fees, the partner claims they are “converted” to a share of related profits –i.e., they become an additional carried interest–and hence eligible for treatment as (deferred) capital gains from the firm. 

Some tax professionals think this conversion waiver works.  Much of this is again the “Wall Street Rule”–the claim that lots do it, the IRS has known about it, and oh it should be justifiable because now the “fee” is (sort of, maybe, kinda) at risk.  It is not really at risk in the way we ordinarily think of investment risk, since these are pre-tax dollars — the managers are not putting after-tax dollars at risk like any other investor is doing.  And as Vic Fleischer commented to the Gothamist blog, “there is a tension between economic risk and tax risk …. The way Bain set it up there’s not much risk at all, so it’s hard to see how this income should receive capital gains treatment.”  Christopher Robbins, NY AG: Bain Capital and others may have skirted tax law, the Gothamist (Sept. 2, 2012). 

I’d guess  that most professionals do not think the conversion scheme works, at least not in most instances.  This would be especially true for those who consider that interpretations of the law should further coherent bodies of law that work as fairly as possible.  And even more tax professionals likely think that the partnership rules should be adjusted to ensure that it doesn’t work, since otherwise we are perpetuating inequities in the tax system that favor the already incredibly rich.

The conversion waiver issue has come to the attention of the public now because the New York State attorney general is investigating private equity firms who may have engaged in this conversion waiver practice.  See Nichnolas Confessore et al, Inquiry on Tax Strategy Adds to Scrutiny of Finance Firms, New York Times (Sept. 1, 2012) (noting that the AG’s subpoenas, issued by the AG’s Taxpayer Protection Bureau, cover firms like Kohlberg Kravis, TPG Capital, Apollo Global, Silver Lake and Bain, and that Bain partners may have saved more than $200 million in federal income taxes, $20 million in Medicare taxes).
It’s not clear on what grounds the New York AG is investigating this issue, which appears on the surface to be primarily a federal income tax issue.  It could be some sort of state-law fraud claim but it could also be a claim that underpayment of state taxes routinely results from the filing posture taken,  Equity partners in firms using the conversion waiver would presumably be able to save on state income taxes through either rate preferences and/or deferral, depending on the state and how much the state’s laws build on the federal filing.  Though New York State does not have a preferential rate for capital gains, if the timing of reporting the income is set by the conversion waiver, the deferral would amount to a significant state tax savings that deprives New York of needed revenues.

[Aside:  By the way, some of the information about the management fee conversion waiver first came to broad public attention in connection with Bain and the trove of documents released at  See John Cook, The Bain Files: Inside Mitt Romney’s Tax-Dodging Cayman Schemes, (Aug. 23, 2012) (noting that the huge cache of Bain financial documents “shed a great deal of light on those finances, and on the tax-dodging tricks available to the hyper-rich that [Romney] has used to keep his effective tax rate at roughly 13% over the last decade”).   These documents, and the further analysis articles available at the site, are worth considering for their own revelation of what Romney’s real business is like and how that does (or doesn’t) suggest he can help our economy as president–it is a business where “opaque complexity” allows the “preposterously wealthy” to engage in “exotic tax-avoidance schemes”, according to the article.  (I have not yet personally perused much of the 950 page trove on Gawker.)  That said, Romney’s campaign issued a statement indicating that the candidate has not benefited from the conversion waiver practice.  We have not, of course, seen enough of Romney’s tax returns and supporting information to be able to judge this matter independently.  The focus on the conversion waiver thus provides yet another reason why candidate Romney should release 10 years of tax returns as other candidates have done.]

There are two additional readable pieces on this conversion waiver issue, plus a scholarly article that anyone wanting to better understand the details can peruse.  Vic Fleischer, a tax prof at Colorado who made his original contribution to academe by writing about carried interest, has an article that sets out the issues well, with an example contrasting the significant difference in after-tax results for a real investor compared to a profits-interest purported investor.  See Victor Fleischer,What’s at issue in the private equity tax inquiry, DealBook, New York Times (Sept. 4, 2012). See also Brian Beutler, Did Bain Capital Execs Break the Law Using a Common Tax Avoidance Strategy? (Sept. 3, 2012). The academic piece is Gregg Polsky, Private Equity Management Fee Conversions (Nov. 4, 2008).  The following two paragraphs are from the conclusion to that piece.

In fact, there are strong arguments that it is not. While managers argue that the safe harbor in Rev. Proc. 93-27 applies to the additional carried interest, there are both technical and conceptual claims to the contrary. Without the protection afforded by Rev. Proc. 93-27, the additional carried interest would be taxable upon receipt if it has a market value capable of determination. Both the context in which the additional carried interest is issued and the specific design features of the typical additional carried interest support the view that additional carried interests are significantly easier to value than prototypical profits interests.Under existing case law, this would mean that the additional carried interest is taxable upon receipt as ordinary income to the extent of its fair market value.

The IRS also has strong arguments under section 707(a)(2)(A), which recasts transactions that are artificially designed as partnership transactions in order to obtain tax benefits, such as character conversion. In the context of fee conversions, the most critical fact that favors section 707(a)(2)(A) re-characterization is the manager’s very limited exposure to risk. As a result, section 707(a)(2)(A) likely applies to fee conversions. If so, the manager’s attempt to convert the character of their management fee income would be thwarted.

cross posted with ataxingmatter

Greg Mankiw attempting to justify carried interest

by Linda Beale

Greg Mankiw attempting to justify carried interest

Greg Mankiw wrote an op-ed in the Sunday Times Money section: Capital Gains, Ordinary Income and Shades of Gray, New York Times (Mar. 4, 2012).

Mankiw notes the historical trend in the US to differentiate between capital gains and ordinary income regarding tax rates (though we have had notable experiements, both in the regular tax and in the AMT, to the contrary). He asserts that there are “good reasons” for the preference for capital gains income–offering only the standard idea of lack of indexation for inflation/deflation as an example.

The purpose of the piece is to justify the carried interest treatment of money managers’ gains from dealing with other people’s money as equivalent to a carpenter who fixes up a dilapidated house and gets capital gains on the sale of the home, though the gains are really paying off the carpenter’s sweat equity. Since the carpenter gets capital gains under our system, he says, why shouldn’t the money manager who does an analogous activity (assuming–which may be a rather big jump– that hedge fund, private equity and other money managers are doing “sweat equity” that adds to the value of the assets under management, and should be viewed analogously to the carpenter).

The problem with making these analogies, especially in the area of capital gains, is that the idea of capital gains is problematic to start with. We’d be much better off with a code that made no such distinction, since there are certainly instances where the distinction is an arbitrary one. Since the line drawing isn’t easy (and it isn’t), then the distinction shouldn’t exist at all in the tax code. That would be the right solution overall.

Nonetheless, the fact that a category is hard to apply generally doesn’t mean that there isn’t a right answer–or at least a better one– in particular circumstances. It is particularly inapt to compare money management with rehabilitation of dilapidated property. Rehabilitation of real property adds “real” value, in that the property is upgraded and will physically last longer than it would have without rehabilitation. Money managers don’t necessarily add any value–they may make money for themselves and others, but there is no real productivity gain in the economy in many (if not most) instances and certainly in any case where the gain is primarily speculative (often the case with hedge funds) or destructive of domestic businesses (often the case with private equity funds).

Private equity fund managers, you will recall, invented the leveraged buyout (or maybe it would be more accurate to say that the idea of the leveraged buyout led to private equity funds). The idea behind leveraged buyouts was to take a stable, money-making company that wasn’t heavily debt-ridden, load it up with debt to cover the acquisition cost of the company, and use the cash flows from the company to pay off the acquisition debt. Private equity funds like Bain Capital could then leverage a minimal investment of their own with the purchased company’s debt to get huge profits, once the debt was paid off with good cash flows (already existing out of the company, with nothing due to the “management” of the money manager). The better the company taken over was, the more its cash flow could be counted on to pay off the debt, the more leverage would be added, the quicker the debt was paid off, and the better the ultimate profit. Sometimes this takeover was relatively harmless for the “good” company, but many times it was harmful–the takeover changes and debt resulted in focus solely on profits and not on long-term investment, and the company’s long-term stability was destroyed. The process was seldom positively beneficial for the company over the long term or for its community (though it may have been for particular shareholders and the managers themselves). The point here, of course, is that the LBO was targeted to (already)”good” companies with low leverage and high cash flow that could easily borrow in the market to cover the cost of the acquisition.

Later, of course, as the age of financial speculation got fully underway, private equity firms started taking over companies that could never expect to pay back the additional debt the LBO loaded them with. The private equity firms made their money in these cases by driving them into bankruptcy and laying off or firing the workers. Equity firms still got their profits out of the deal by selling off the components. But the companies (and especially their workers) were done for–if the companies survived at all, they were just parts of some conglomerate with very different functions.
Making money from managing other people’s money, in other words, is not per se productive for the economy as a whole and is not something we should reward with low taxation that acts as an incentive to the activity. We should recognize the money manager’s take as what it is–compensation for work done–and tax accordingly.

As an aside, I’ll note that it wouldn’t be unreasonable to have a handyman take ordinary income on his share of the profit that serves as reasonable compensation for his labor, but in most cases that’s a difficult facts and circumstances issue for the Service to sort out after the fact. One reason carried interest is such an obvious place to repair the problematic categorization of labor income as preferential capital gains is that there will be a partnership and there will be records of “management fees” and “carried interest allocations”. Given our sophistication about partnership allocations, identifying and classifying the carry as ordinary income is a relatively simple endeavor.

crossposted with ataxingmatter

James Kwak
has a take on it also.

Romney’s Wall St. J. Interview with Gigot–Protecting the Rich

Romney’s Wall St. J. Interview with Gigot–Protecting the Rich

[edited to rephrase and correct typos 12/26/11 5 pm]
Joseph Rago and Paul Gigot interviewed Mitt Romney on his ‘vision’ for America–“On Taxes, ‘Modeling’, and the Vision Thing”, Wall St. J. Dec. 23-24, 2011, at A13.  In it, Romney reveals the way patrician wealth has affected his values, casting President Obama as a “European social democrat” and suggesting that contrasts with his own belief in a “merit-based opportunity society–where people earn their rewards based upon their education, their work, their willingness to take risks and their dreams.”  
Now everybody likes the idea of people being able to advance based on merit, rather than on crony capitalism, improper influence or whatever.   The problem with suggesting that America is a ‘merit-based opportunity society’ is that it isn’t much of one anymore: America in this second Gilded Age is primarily a wealth-and-status-based opportunity society. 
  • Education:  Even Romney admitted (obviously unintentionally) that wealth makes a real difference, since he noted that rewards depend in part on education.  People with wealth receive the finest educations from pre-K through post-graduate, getting preferences at the best children’s academies in Manhattan and at the highest ranked universities like Harvard and Yale.  People without wealth lose out from the very beginning, with inferior schools that are no longer fully supported by the public, as charter and for-profit schools take over offering inferior educations that no patrician family would ever accept.  The poor and middle class take on enormous loans and work loads to finance even their public university educations, since state support has slipped down to a mere 20-30% of the cost of that education.  That makes study and grades and success much more difficult for them. 
  • Working hard (with Contacts/Influence/lobbyists):  The wealthy are introduced early to the most important people of influence in society, like the Vanderbilts and the Astors of old, the private equity fund managers and the Wall Street bankers that can smooth their way through all the trials and tribulations of their ‘work’ careers–i.e., becoming owners of major league baseball team when you have no relevant experience (George W. Bush, with the aid of his papa and his papa’s influential and rich partners) or setting up a venture capital fund (like Romney’s Bain Capital). These connections ultimately permit the wealthy to mingle in a monied society that offers the right contact for every venture to succeed–including lobbyists to help a wealthy entrepreneur get his business going and ability to ‘invest’ in politicians who are willing to risk alienating the middle class to support preferential taxation of the rich. 
    • By the way, lots of the not-rich work quite hard, often at thankless jobs that provide no cushion to deal with life’s difficult blows or at a job that, at minimum wage, still leaves their family below the poverty line.  Without the contacts and influence that smooth the way of the rich, there chances of moving up are much more limited.  If they persevere, have an entrepreneurial idea, and catch a break, they may be able to move beyond where they are, but they have to do a lot more than just ‘work hard.’  
  • Taking Risks (and Getting Subsidies and Preferential Tax Provisions):  The poor take a risk every time they get up in the morning–will their health hold out so they can keep working? will they be able to make it to their job in that car that needs a new starter? can they manage to arrange for someone to take care of their kids while they work or will they have to be “latch-key kids” yet another day?  But they don’t usually have the kind of capital nest-egg to take a risk with in the way that Romney means it–the excitement of opening a new business demands from the poor and near-poor Herculean efforts to pull together family, friends, and workers to support their business ideas.  Those with money, on the other hand, have a head start on all of this.  Bill Gates’ parents offered him an educated life of relative ease; he could ‘play’ in the garage on that dream of his rather than running heavy machinery or working behind a counter at a McDonalds.  And those with contacts and money are able (and willing) to hire the best lobbyists to ensure that they get all the tax-advantaged benefits and subsidies that they can finnangle (or buy) from local, state and federal legislators for their activities.  That includes favorable tax provisions that allow them to keep a significant percentage of their wealth (and to fight for even more favorable provisions), such as the carried interest provision that gave Romney a preferential rate on almost all of his compensation income, the preferential capital gains rate that gives all the wealthy a low tax rate on their income from trading stocks and bonds with each other, and the various ways that the tax code subsidizes the kinds of personal deductions that provide the most benefit to those with money–from the charitable contribution deduction (including the ability to give away stock and claim a deduction for its value rather than for your actual basis) and the mortgage interest deduction (for interest on home loans up to a million plus $100,000) to all of those provisions that allow the wealthy to retire well–pension plans, exclusion of life insurance benefits, etc.  Then there are the many subsidies they get various governments to provide for their businesses, presumably by using those long-term family/status connections to wine, dine and influence.  They include low-cost loans such as those enjoyed by Romney’s Bain Capital for various businesses that Bain Capital was ‘turning around’.  (Handily, they can make low-taxed profits for themselves even when their turnarounds fail, with all those subsidies, so that the taxpayer sometimes ends up paying  for their losses along with the fired workers.)  See the links provided in the posting yesterday on Romney’s reluctance to release his tax returns, which discuss some of the subsidies and other benefits to Romney’s business. 
That’s not a merit-based opportunity society:  it’s an influence-based society, where the poor and even most of the middle class are working against long odds to make headway. 
And there’s not much evidence that Romney recognizes this fundamental difference in existence of the well-off and the not-so-well-off here in America.  Take the Gigot story’s discussion of tax policy and what kinds of “reforms” Romney supports.  The Journal apparently thinks Romney is too timid on ‘risk-taking’ because he didn’t espouse the kind of tax agenda that the Journal supports–moving to a consumption tax–like the national sales tax– that shifts most of the tax burden to ordinary folks (since they will pay tax on most or all of their  income since they spend most of it on food, shelter, clothing and other necessities) and leaves a zero percent tax rate on the capital gains, dividends, and other income from capital that makes up most of the income of the wealthy and little of the income of everybody else.  Why, the Journal notes, Romney’s plan merely calls for extending the Bush tax cuts, cutting the statutory corporate tax rate from 35% to 25%, and eliminating capital gains and dividends taxes only for those who make $200,000 or less.  Romney won’t even say he supports a consumption tax til he’s studied it more, though he likes the purported “simplicity” of a flat tax.    Romney also says he likes “removing the distortion in our tax code for certain classes of investment”.  This means that Romney does not understand the real economics of the consumption tax and the so-called ‘flat tax’, both of which result in taxation of 100% of the income of the poor and near poor and most of the middle class while leaving the rich with a minimal tax burden.  Any system for alleviating that burden (such as a low-level exemption at the bottom of the income scale) would thrust a truly burdensome recordkeeping requirement on those least able to cope with it.  Especially for versions that merely zero out the tax rate on income from capital, distortions would be magnified: the categorization of income into different types is one of the primary distortions in our system, and any plan to eliminate taxes on one type of income while retaining them on another increases distortions rather than removing them!
What about Romney’s saying he won’t propose cuts in individual tax rates for those making more than $200,000?  The Journal seems to think that is rather cowardly, since such a proposal accepts President Obama’s linedrawing on where rate cuts might be reasonable.  Now, aside from the failure to consider dropping the entire bunch of Bush tax cuts and letting all the rates go back to the level that they were when Bush took office (which might well be the best tax reform the Congress could do at this point), Romney should be commended for at least recognizing that the wealthy have gotten a fistful of tax gifts from the Bush individual tax cuts (and, indirectly, from the various corporate tax provisions that have allowed companies to pay less and less into the federal fisc) and for not wanting to proffer even more. 
But here’s the rub.  Romney doesn’t recognize the damage from the wealthier among us continuing to get even wealthier while the vast majority suffers stagnation and decline:  as the concentration of income increases at the top and inequality becomes the defining characteristic of this society, opportunity for all is threatened as is democracy itself.  Tax policies that could serve as a deterrent to that wealth buildup at the top–e.g., a stiffer, progressive estate tax, a financial transactions tax to discourage trading and capture a tiny amount in connection with those secondary market trades amongst the wealthy, and bracket expansions that would create a more progressive set of tax rates for the highest income that would distinguish between those who have $400,000 a year and those who have $2 million a year–aren’t even on Romney’s radar screen.  He’s content with the current system’s distribution, one that is highly favorable to the wealthy.  As a recent FED Finance and Economics Discussion Series article made clear, inequality has made permanent inroads and tax policies haven’t done much to dampen them.  See Jason DeBacker et al, Rising Inequality, Transitory or Permanent? New Evidence from a U.S. Panel of Household Income 1987-2006.
Romeny’s made it clear that he isn’t about to challenge the status quo of an easy tax life for the wealthy.  Here’s what he said to the Journal on the question of making sure that the wealthy never see any kind of a tax increase.
“My intent is to simplify our tax code and create growth, and so I will also look to see whether the top one-half of 1% or one-thousandth of 1% or top 1% are still paying roughly the same share of the total tax burden that they have today.  I’m not looking to lower the share paid for by the top.”  Wall St. J., Dec. 24-25, 2011, at A13 (quoting Romney).
So after a decade of cutting taxes on the wealthy and passing more and more provisions that benefit the wealthy in particular either directly or indirectly, Romney declares today’s status quo as the perfect state for things to be in–the current low taxes on the wealthy, in perpetuity, are his goal.  And while we may applaud him for not intending to lower taxeds further on the wealthy, it is hard to see how continuing current tax policy towards the wealthy makes sense for the fisc or for democracy.   Carried interest–won’t be taxed under Romney as the ordinary compensation that it is.  Mortgage interest deduction on million-dollar loans–won’t be pulled back to a more reasonable amount such as the interest on a loan that is 80% of the value of the median-priced US home.  Charitable contribution deduction for value rather than basis in stocks contributed–won’t get rid of that one.  Establishment of new brackets to recognize the drastic expansion of incomes at the top so that those with progressively more income are paying progressively more in taxes–won’t happen under Romney.  Why?  Because he is going to make sure that the top 1%, the top 1/2%, the top 1/1000% don’t pay less, but also don’t pay a bit more in taxes than they are paying now, this perfect state where the GOP wants to cut people off Medicaid to save money, turn Medicare into a ‘premium support’ system that will shift more and more of the burden of health care in one’s old age to the vulnerable elderly with a pension they can’t count on and a Social Security system that the GOP is trying to ensure that they can’t count on.
Most tax “simplification” promoted by lobbyists won’t create growth–it is much more likely to result in tax loopholes that the wealthy can drive a truck through.  Refusing ever to increase taxes, even on the ultra-rich who can clearly afford to pay more (without really noticing the difference in spending power) won’t create growth–it most likely will result in a stagnant economy where the burdened middle class gradually falls into the ranks of the New Poor. 

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

Carried Interest: Senate Getting Swayed by Lobbyists

by Linda Beale

Crossposted with Ataxingmatter

Carried Interest: Senate Getting Swayed by Lobbyists

The Senate started discussion of the “extenders” legislation on Tuesday. IN the House version, HR 4213, there is finally a carried interest provision, though it is a weak one. (Recall that carried interest is the amount that managers of hedge, equity and other partnerships charge for managing assets of the partnerships, so it is compensation income but these “profits” partners claim that their allocations of capital gains from sales of partnership assets should retain capital gain treatment as such allocations do to partners who have contributed capital to a partnership, even though it is a payment for the managers’ services. See earlier postings on A Taxing Matter, here and here (JCT reports) and here (Weisbach study). ) After several years of attempts to tax wealthy fund managers on their compensation the same way that others are taxed–i.e., at ordinary income rates–the House included a revenue offset provision in the extenders bill that will eventually tax 75% of the carried interest at ordinary income rates.

Lobbyists responded that they would work on the Senate to make the bill less distasteful to their clients. So they are lobbying for even lower rates in the Senate. And they are focusing on what they think will be a sympathetic case–family partnerships that run family real estate businesses. A substitute amendment is under consideration, which would change the percentages and grant even more favorable preferential treatment to fund managers for their compensation for services–65% generally, with an even more favorable 45-55 split if the assets are held by the partnership for at least seven years. Text of the substitute amendment, a summary and other information is available at the Senate Finance Committee website on HR 4213.

Just a few comments:

1) the purported economic justification for privileged treatment of fund managers–that there won’t be as much management of funds or funds that invest–is absurd. Fund managers were making money head over heels but still will make most of that money even if they pay taxes on their services income the same way ordinary folks do. They won’t stop acting as fund managers if they have to pay ordinary income rates on their income. There will not be any fewer funds if the managers don’t get the special privileged tax rates that they claim for carried interest. There won’t be any less investing activity. There won’t be any great harm to family partnerships or real estate partnerships or hedge funds or private equity funds. None of the managers of any of these funds merit the exceptionally lucrative tax break that they have been claiming in the carried interest mechanism, and none of them will receive so low a return that they will quit the business if they have to pay the same tax rates that ordinary Americans pay on their services income.

2) Any provision that splits the rate structure is arbitrary, makes the tax Code more complex, invites gamesmanship on holding periods, and will be passed only as a way to appease wealthy donors so that they will continue contributing lots of funds (that should have been paid to We the People as taxes) to individual House and Senate campaign chests of those that are holding out for a “softer” bill.

3) there is no justification whatsoever for a half-way measure in which fund managers are privileged to pay low rates on a substantial part of their income from services, while ordinary taxpayers continue to pay ordinary rates. That sort of “compromise” merely proves that the House and Senate are willing to sell out ordinary taxpayers and continue to favor the wealthy and that fairness loses when the House or Senate is thinking about campaign contributions. The split just proves the outsize influence that lobbyists for the shadow banking system still hold over Congress, even though the unregulated shadow banking system (including hedge and private equity funds and real estate partnerships) was a significant cause of the financial crisis.

4) Accordingly, the House compromise, and the Senate substitute, make a mockery of the basic fairness concept in taxation. The problem with carried interest is that it allows a few financial managers a preferential tax break on their compensation income. The entire Congress is now aware of the fairness problem. In spite of their awareness that there is no justification for the tax break that these wealthy fund managers have claimed for years, lobbyists for the privileged few who have enjoyed this tax break are pushing to retain the break. Since we know that the Senate and House understands that this is an unfair tax break that ordinary Americans do not enjoy and that cannot be justified in any way as a necessary tax expenditure to encourage an activity, then it must mean that the House and Senate are too corrupt to pass decent legislation that treats these wealthy fund managers like ordinary people.

Carried Interest: prospects?

by Linda Beale
crossposted at Ataxingmatter

Carried Interest: prospects?

At the ABA Tax Section meeting in Washington last weekend, there was surprisingly little talk about the carried interest proposal. Carried interest, for those who don’t work often in the partnership area, is the way that managers of real estate, hedge, and equity partnerships receive a generous payment for managing the fund–usually a “2 and 20” 2% of the assets under management annually and 20% of profits fee for services. The 20% is claimed to be gains from asset dispositions rather than services (providing a preferential rate in some cases, as well as no payroll taxation) and often has been deferred through offshoring.

Various tax experts have called for taxing both the fee and carried interest as ordinary compensation subject to payroll taxes and always taxable at ordinary rates. That proposal has been suggested in Congress at various times as a revenue raiser, but it has not yet been enacted as part of a bill, since the Senate has not included the House-passed version. The Real Estate Roundtable has lobbied strenuously against the carried interest provision in past years and successfully joined with private equity, hedge fund, and venture capital firms to defeat the idea.

There is talk now of including it in the jobs bill that Congress hopes to pass before the end of May. See Real Estate Group PUshes to Soften ‘Carried Interest’ Tax Rise, Bloomberg, May 8, 2010. Naturally, lobbyists are busy trying to eliminate or modify the provision. The head of the Real Estate Roundtable noted that the group is arguing for a “blended” tax rate that would provide a rate between the capital gains preference and ordinary rates, or a provision that would apply the capital gains rates for gains from investments that the partnership holds for at least 2 years. A spokesperson for the National Venture Capital Association siad that “we’re not accepting this as a fait accompli…we have not waived from our position.” Id.

The argument for taxing the carried interest of “profits” partners as compensation income, however, is strong: there is little justification for further complicating the Code with blended rates or a new long-term holding period for the capital gains rate. These managers should pay tax at ordinary rates and should also be liable for the ordinary payroll taxes on their full compensation income. Sure, they won’t like it and they “won’t waiver” from trying to push the Senate to ensure their cozy deal. But that is not a satisfactory argument for failing to make this change which is required for fairness’ sake.

(2 and 20 corrected by Rdan)