Carried Interest Taxation

Unless your Blackberry, laptop and PC died today, you know about the hoopla surrounding the revelation that Blackstone negotiated as part of its IPO to share in the tax savings caused by the structure of their transaction.  We find it hard to understand what all of the fuss is about.  Let's review the bidding-

• Blackstone partners sold partnership interests in the IPO.  By making a common tax election authorized by Section 754 of the Internal Revenue Code, the partnership was entitled to "step up" the basis of assets by the gain recognized by Blackstone partners.  This step up created an amortizable goodwill asset, which can be written off over 15 years.
• Blackstone partners negotiated as part of the IPO to have the beneficiaries of the amortization pay to the partners 85% of the tax savings created by the increased amortization deductions. 

So, these amounts received by Mr. Schwartzman, et al. are not dollars that the fisc would otherwise receive.  Instead, it is a contractual allocation of the value of the tax savings.  Parties do this kind of contractual allocation all of the time.  It does NOT represent an abuse of the tax system. 

We think that some are trying to put a black hat on these guys, which does not appear to be true and should be no more relevant to the debate than the fund managers' painting themselves as the champion of the working class.

Senator Hillary Clinton (D-NY) has joined fellow Democratic Presidential candidates John Edwards and Barack Obama in declaring her support for raising tax rates on carried interests.  This position is interesting given that her constituency includes many private equity managers.

Another interesting aspect of Senator Clinton's endorsement is that it comes after this column from Paul Krugman in the NY Times supporting the effort to raise the tax rate on carried interests.

Our take on the import of Presidential candidates' supporting this measure is that even if the current legislative proposals die, we should expect the introduction of similar measures in the next Congress.  So the debate might be around for some time.

Senator Barack Obama (D-IL) becomes the second Democratic Presidential candidate to take a position in the carried interest tax debate.  Senator Obama announced today that he was becoming a sponsor of the Blackstone Bill currently introduced in the Senate, which would tax publicly traded partnerships earning carried interests as corporations.

Tonight we'll take up with Mr. Diamond and Mr. Campbell.

Senator Grassley (R-IA) opened the hearings this morning with a statement that Congress is seeking to "close loopholes," not raise taxes.  With the tone set, some interesting testimony occurred this morning.

• CBO Director Peter Orszag inferred that the carried interest problem is symptomatic of problems with taxing capital gains at lower rates than ordinary income, creating incentives for taxpayer to characterize income as capital gains.  We're not sure if he is a proponent of a single rate for all income and capital gains (think back to the 1986 Act), but he definitely hinted in that direction.

• Assistant Treasury Secretary for Tax Policy Eric Solomon testified that the proposed carried interest legislation could hurt the economy, an apparently strong statement that the Administration will oppose attempts to raise taxes on carried interests.

The taxation of carried interests consists of three basic issues:

· Is the recipient of a carried interest taxable on the receipt of the carried interest?

· What is the character of the carried interest holder’s income allocated on account of the carried interest?

· What is the character of any gain or loss if a holder of a carried interest sells that interest?

Until the current debate, the controversy regarding the taxation of carried interest has focused on the first issue, while most people in the tax community have agreed that the second and third issues are relatively settled. For the next few days, we’ll examine the development of the law around the issuance of carried interests up to the present time.

The starting point for understanding the current tax rules regarding the taxation of issuance of carried interests is a fundamental distinction in the economic rights of partnership interests that a partnership can issue. The partnership can issue a “capital interest” (i.e., a right to the existing value of the partnership’s assets) or a “profits interest” (i.e., a right to the future operating profits and appreciation of the partnership’s assets). Congress designed the partnership tax rules to accommodate flexible economic arrangements so that the partners do not have to own profits interests in the same proportion as capital interests. This principle has been a fundamental basis of the statutory rules governing the taxation of partners and partnerships since 1954.

To illustrate the difference between capital and profits interests, consider the following example. A and B form a partnership cleverly named AB. A contributes $10 and agrees to manage the business of the partnership. B contributes $90 as the financial partner, but takes no part in the management of the business. A and B agree that AB will return the capital to A and B in proportion to the way it is contributed, but that AB will share profits 50% to A and 50% to B. AB purchase an asset with the $100 contributed by A and B.

Immediately after the contribution, A has a right to receive a return of his capital ($10) and B has a right to receive a return of her capital ($90). In addition, if AB returns more than that $100, A will get 50% of the excess and B will get 50% of the excess.

A’s initial interest in AB consists of a 10% capital interest ($10 contributed by A/$100 total contributed) and a 50% profits interest. B’s initial interest in AB is the converse, a 90% capital interest ($90 contributed by A/$100 total contributed) and a 50% profits interest).

From 1954 (and before) until 1971, the tax law seemed relatively clear that A’s receipt of a profits interest greater than his capital interest was not taxable to A. However, if A had received a capital interest for services, the rules were clear that the value of that capital interest was taxable to A upon receipt.

In our next chapter, we’ll chronicle the sagas of two carried interest holders, Sol Diamond and William Campbell, who were the unlucky parties against whom the IRS for various reasons challenged the taxability of the receipt of carried interests.