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  1. 1. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 “Two and Twenty” Partnership Profits in Hedge Funds, Venture Capital Funds, and Private Equity Victor Fleischer* Draft of Feb. 22, 2006 Private investment fund managers take a share of the profits of the partnership as the equity portion of their compensation. The tax rules for compensating service partners create a planning opportunity for managers who receive the industry standard “two and twenty” (a two percent management fee and twenty percent profits interest). Compensation is routinely deferred and converted from ordinary income into long-term capital gain. This quirk in the tax law also allows the very richest workers in the country to pay tax on their labor income at a lower rate than an investment banker, a doctor, a public school teacher, or a bus driver. This Article argues that changes in the investment world – the growth of private equity and hedge funds, Sarbanes-Oxley, the adoption of portable alpha strategies by tax-exempt institutional investors, the preference for capital gains, and aggressive tax planning – require reconsideration of the partnership profits puzzle and warrant fundamental reform. The equity compensation of service partners raises issues of both timing and character. Most prior scholarship has focused on the timing/deferral problem: a profits interest in a partnership has economic value, but the tax rules – including regulations recently proposed by the Treasury Department – allow taxpayers to count only the liquidation value of the partnership interest and ignore the option value. Because the liquidation value of a profits interest is zero, the granting of a profits interest is not treated as a taxable event. I argue that this focus on timing is misplaced. While I recognize that deferral creates a gap between the economics of a profits interest and its treatment for tax purposes, the gap is defensible on consistency grounds. Current law is consistent with a broadly shared reluctance to taxing endowment and with the tax code’s generous treatment of deferred compensation in the context of sole proprietorships or corporations. An unintended consequence of the focus on the timing problem has been neglect of the character issue. Changes in the private equity market have made the character issue more important than it once was, and I argue that reforming the character treatment of service partners is necessary and normatively appropriate. So long as the partnership’s promise to pay remains unfunded and unsecured, deferral is arguably * Acting Professor, UCLA School of Law; Associate Professor, University of Colorado (effective summer 2006). I thank the participants at the Tax Section of the AALS 2006 Annual Meeting for their comments and suggestions [add more]. I also wish to thank Steve Hurdle for his wonderful research assistance. In recognition of his patient guidance on this project, any errors or omissions that remain should be attributed to Eric Zolt. 1
  2. 2. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 defensible. But when service partners do receive compensatory allocations later, those allocations should be treated as compensation. As such, they would be taxed at ordinary income rates rather than treated as capital gain, and the partnership would receive an ordinary deduction or would capitalize the expense. This approach closely follows Professor Mark Gergen’s (1992) proposal, albeit for somewhat different reasons than Gergen. 2
  3. 3. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 INTRODUCTION The scholarly literature on the tax treatment of a profits interest in a partnership is extensive and daunting.1 It is remarkable that so many pencil tips have been broken2 over the question. Setting aside a few hiccups – the Diamond and Campbell cases well known to partnership tax gurus – generations of tax lawyers have been comfortable advising their clients that the grant of a profits interest in a partnership does not give rise to immediate taxable income. Regulations recently proposed by the Treasury would quasi- codify this longstanding rule. But while the law has changed little, the investment world has changed dramatically since the days when mortgage broker Sol Diamond sold his partnership interest for $60,000 and reported the sale as capital gain. Partnership tax rules designed with small businesses in mind are now routinely used by billion dollar investment funds. These taxpayer-favorable rules do not scale up well. This Article takes a fresh look at the partnership profits interest puzzle by closely considering one institutional context – and in my view the most important context – in which the rules currently apply. I focus on “two and twenty,” the industry standard compensation package for the general partners of private investment funds. Seven institutional details prove important. Tax Rate on Capital Gains. Previous scholars who have considered the problem of how to tax a profits interest in a partnership have focused on the timing problem. The most thoughtful scholarship was written when the gap between the top marginal rate on ordinary income and the top rate on capital gains was three points. It is now twenty points, making the character issue more important than it once was.3 The Private Equity Boom. The private equity market has grown enormously in the last twenty years. Previous scholars have discussed the problem in the context of small businesses and real estate partnerships, like those of Sol Diamond and William Campbell.4 But the issue arises perhaps most often, and certainly with greatest consequence, for private investment funds.5 Discussing the problem in the context of the Diamond and Campbell cases is like drafting stock dividend rules to accommodate 1 Cunningham, Schmolka, Gergen, Cowan, etc. See Martin B. Cowan, Receipt of an Interest in Partnership Profits in Consideration for Services: The Diamond Case, 27 Tax L. Rev. 161 (1972); McKee, Nelson & Whitmire, Federal Taxation of Partnerships and Partners, (3d ed. 1997) at ¶ 5.01-5.10; Cowan, Receipt of a Partnership Interest for Services, 32 NYU Inst. on Fed. Tax’n 1501 (1974); Cunningham, Taxing Partnership Interests Exchanged for Services, 47 Tax L. Rev. 247 (1991); Schmolka, Taxing Partnership Interests Exchanged for Services: Let Diamond/Campbell Quietly Die, 47 Tax L. Rev. 287 (1991); Hortenstine & Ford, Receipt of a Partnership Interest for Services: A Controversy That Will Not Die, 65 Taxes 880 (1987); Gehrke, Section 83 Applied to Partnership Transactions: The Road to Certainty in Planning and Controlling the Tax Consequences of Exchanges of Partnership Interests for Services, 13 Fla. St. U. L. Rev. 325 (1985); Banoff, Conversions of Services Into Property Interests: Choice of Form of Business, 61 Taxes 844 (1983). 2 Tax lawyers generally use pencils, not pens, so it seemed inappropriate to talk about ink being spilled. 3 In 1988, the top marginal rate on ordinary income was 28%; it is now 35%. The top rate on long-term capital gain, by contrast, has dropped from 28% to 15%. 4 Cite to Diamond, Campbell. 5 Cite to New York State Bar report on the proposed regs. 3
  4. 4. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 Myrtle Macomber.6 Human stories and judicial opinions make the problem more accessible for students and scholars, but they can also distort public policy considerations. The Missing Preferred Return. Some investment funds further exploit the tax treatment of a profits interest in a partnership by failing to index the measurement of profits to an interest rate or industry benchmark. This phenomenon, which I call the “Missing Preferred Return,” allows the fund managers to maximize the present value of the carried interest and accept lower management fees than they otherwise would, thereby maximizing the tax advantage.7 Sarbanes-Oxley. Scholars believe that the enactment of Sarbanes-Oxley in [2003] encourages companies to go private or stay private. The rising cost of public equity makes private equity more attractive, which in turn increases demand for private equity managers. Portable Alpha. Institutional investors have recently become enamored with the investment concept of “portable alpha,” which stresses the value of active financial intermediaries over passive portfolio management.8 Among the early adopters of the portable alpha concept are pension funds, endowments, and other tax-exempt investors. This detail is significant not just because it increases the demand for private investment funds, but because the presence of tax-exempt limited partners in these funds creates an opportunity for tax savings. When the fund managers defer income and convert what ought to be ordinary income into capital gain, limited partners lose what may be a valuable deduction. If the limited partners are tax-exempt, however, they have no objection to losing the tax deduction.9 The benefits of deferral are strongest where there is a tax-indifferent counterparty, and tax-exempt LPs serve this role. 409A. Deferred compensation reforms (the recent changes to section 409A) have made it somewhat more difficult to achieve deferral in the corporate context. The comparative advantage of the partnership form has become that much more enticing. Gamesmanship. Finally, as the stakes have gotten bigger, GPs have become more aggressive in converting management fees, which give rise to ordinary income, into additional shares of carried interest, which give rise to capital gain. GPs are also aggressive in shifting income offshore. 6 Cite to Eisner v. Macomber; Cite to Tax Stories, Business Tax Stories. 7 See Victor Fleischer, The Missing Preferred Return, J. Corp. L. (forthcoming 2006). Buyout funds and hedge funds use a hurdle rate which also increases tax savings compared to a true preferred return. 8 Portfolio returns can be divided into market risk (beta) and the value added by managers (alpha). By investing in securities whose returns are less correlated with the market, the portfolio manager creates so- called portable alpha. The cost of acquiring beta can be reduced by investing with derivatives, e.g. by purchasing an option on the S&P 500 instead of a forward contract. This frees up more capital to invest in venture capital, private equity, and hedge funds, where alpha returns are higher. See generally [sources on portable alpha; Yale endowment manager; dust up over the Harvard endowment.] 9 See Victor Fleischer, The Rational Exuberance of Structuring Venture Capital Start-Ups, Tax L Rev. 4
  5. 5. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 Together these institutional factors amount to a quiet revolution in equity compensation. The most talented financial minds among us – those whose financial status is measured by whether they are “airplane rich” – are increasingly leaving investment banks and other corporate employers to start or join private investment funds organized as partnerships.10 When they do, they not only increase their income, they pay a lower tax rate on that income. The partnership tax rules sanction this gap between the economics of a profits interest and its tax treatment. Most tax practitioners and tax scholars agree that the status quo is the right result as a matter of policy, though there is little agreement about why this is the right result. The government seems to accept the distortion mainly as an administrative necessity. Commentators have raised valid concerns about taxing endowment. Because profits depend in part on the future labor efforts of the service partner, taxing a profits interest at the time of grant would go beyond what we normally think of as ability to pay. Possessing a profits interest in an elite hedge fund or venture capital fund greatly increases one’s likelihood amassing future wealth. But so does making partner at Cravath, or, for that matter, graduating from Harvard Law School or attending Exeter.11 Reaching the increased ability to earn wages from the performance of future services is consistent with a purely economic concept of income, but goes beyond how we normally administer the income tax into the realm of endowment taxation. On the other hand, the reluctance to tax endowment does not necessarily prohibit other timing solutions, such as accrual taxation or a special additional tax on later distributions. The strongest justification for the status quo is consistency. Eliminating deferral in the partnership context would disadvantage partners vis-à-vis corporate employees, who also enjoy a deferral advantage when they are willing to forgo current compensation in exchange for an unsecured, unfunded promise to pay. The timing advantage of a profits interest may offend one’s sense of equality, but there is nothing special about a partnership interest that warrants making service partners worse off than corporate employees. And so the status quo is, perhaps, defensible with respect to timing. What probably12 cannot be justified is the conversion of labor income into capital gain. Here, the partnership tax rules are clearly more favorable than the corporate rules, and the widespread presence of tax-exempt LPs makes the problem much more acute than in the corporate context. I conclude that fundamental reform of the taxation of service partners in a manner advocated by Gergen (1992) is appropriate. A profits interest should be treated as contingent compensation. It should be deferred so long as it is nothing more than an unsecured, unfunded promise to pay money in the future, but when that income is 10 You are airplane rich if you own your own private jet. 11 I am hardly the first to make this observation that taxing future services amounts to taxing human capital. See Cunningham, supra note 1, at xx (noting “the usual example” of a law firm associate promoted to partner). 12 Interestingly, this result of steeply declining marginal rates at the very top is arguably consistent with optimal income tax models. The status quo could also be defended on subsidy grounds, although the subsidy is likely much broader than we would desire if the goal was to subsidize activities that generate positive externalities, like research and development of new technologies. 5
  6. 6. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 received, it should be treated as ordinary income and not capital gain (and deducted or capitalized by the partnership). I turn next, in section II, to the institutional practices that motivate this Article. In Section III, I consider the timing question. In Section IV, I consider the character question. Section V concludes. II. Two and Twenty: The Quiet Revolution in Equity Compensation Private investment fund managers pay a smaller amount in taxes, as a percentage of their labor income, than their counterparts at investment banks and other corporations. For that matter, they pay tax at a lower rate than the rest of us as well. They are not paid like corporate employees, with a mix of cash and stock or stock options. Instead, in addition to salary, they receive distributive shares in the partnerships they manage. Specifically, private investment fund managers receive two and twenty: an annual fee of two percent of the capital under management, plus twenty percent of the partnership profits.13 The best managers receive slightly more, and new managers receive slightly less, but the basic compensation design is more or less the same. And with good reason. The profits interest portion of this compensation, also known as the “carried interest,” is tax-advantaged. It is treated as investment income, not labor income, and unlike salary it is tax-deferred and often taxed at lower capital gains rates. A. The Tax Treatment of Two and Twenty14 The basic elements of fund organization are remarkably similar across different types of private investment funds. Venture capital funds, mezzanine funds, hedge funds, and buyout funds all share some basic characteristics. Funds are organized as limited partnerships or limited liability companies (LLCs) under state law. Investors become limited partners (LPs) in the partnerships and commit capital to the fund.15 A general partner (GP) manages the partnership in exchange for an annual management fee, often two percent of the fund’s committed capital (the “two” in “two and twenty”). The GP also receives a share of any profits; this profit-sharing right is often called the “carry” or “carried interest.” Most often, the GP receives twenty percent of the profits (the “twenty” in “two and twenty”); a few GPs receive higher or lower percentages. The carried interest helps align the incentives of the GP with those of the LPs: because the GP can earn significant compensation if the fund performs well, the fund managers are driven to work harder and earn profits for the partnership as a whole. 13 There is some variation in the amount of pay received, but the legal form and amounts are remarkably similar across different types of funds. 14 Portions of this discussion are drawn from Victor Fleischer, The Missing Preferred Return, J. Corp. L. [Discuss rosenblum article on character; Investment Research Associates Ltd., et al. V. Comm'r, TC Memo 1999-407 (December 15, 1999).] 15 GPs commonly contribute 1% or 2% of the capital to the fund. 6
  7. 7. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 After formation, the GP deploys the capital in the fund by investing in companies, known as Fund Organization portfolio companies. In some Investment Professionals funds, after making the initial LP LP LP LP LP investment, the GP may become a GP formal or informal advisor to the companies. (In certain kinds of Carried Interest Capital Interests hedge funds, GPs direct the fund’s Private Equity Fund I, L.P. purchase of liquid securities and do not get involved in the underlying company.) Whatever the arrangement, the GP’s duties with respect to investments continues Portfolio Companies during the life of the partnership; at the time it is granted, the carried interest mostly represents compensation for future services. The carried interest creates powerful economic incentives for the GP. The GP is itself a partnership or LLC with a small number of professionals as members. The GP receives a management fee that covers administrative overhead and pays the managers’ salaries. The management fee is fixed and does not depend on the performance of the fund. The carry, on the other hand, is performance-based. Because private equity funds are leanly staffed, a carried interest worth millions of dollars may be split among just a handful of managers. Timing. The tax law creates a gap between the economics of the carried interest and its treatment for tax purposes. At the moment a fund agreement is signed, the GP receives something of economic value. The carried interest has an “option value”: the possibility that the value of the fund will increase, making the carry valuable. To be sure, the current value of this interest is uncertain, contingent as it is on the efforts of the GP and subject as it is to all sorts of external risks. But it has some economic value nonetheless. From a purely economic standpoint, there is little question that the GP has received something of value at the moment the partnership agreement is signed. The tax law rarely follows pure economic conceptions of income, however, making the question of whether the granting of a profits interest gives rise to taxable income a tricky question. Partnership interests are often divided analytically into capital interests and profits interests. A profits interest is an interest that gives the partner certain rights in the partnership (thus distinguishing it from an option to acquire a partnership interest) but a current liquidation value of zero. A capital interest both gives the partner certain rights in the partnership and also has a current liquidation value. When a partner receives a capital interest in a partnership in exchange for services, the partner has immediate taxable income on the fair value of the interest. Determining the proper treatment of a profits interest is more difficult, however, as its current economic value is difficult to determine. 7
  8. 8. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 In Diamond vs. Commissioner, the Tax Court (affirmed by the Seventh Circuit) held that the receipt of a profits interest “with determinable market value” is taxable income.16 A profits interest in a partnership rarely has a determinable market value, however. Some uncertainty remained until 1993, when in Revenue Procedure 93-27 the IRS conceded that profits interests would not be taxed currently and established that having no current liquidation value would be the hallmark of a profits interest.17 Rev. Proc. 93-27 spelled out the limits of this safe harbor. To qualify, the profits interest must not relate to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease, must not be disposed of within two years of receipt, and the partnership must not be publicly traded.18 Rev. Proc. 93-27 defines a capital interest as an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership.19 A profits interest is defined as a partnership interest other than a capital interest.20 The determination as to whether an interest is a capital interest generally is made at the time of receipt of the partnership interest.21 The Treasury recently proposed regulations (and an accompanying notice) that would quasi-codify the status quo.22 The proposed regulations and notice, like Rev. Proc. 93-27, require that the partnership’s income stream cannot be substantially certain and predictable, that the partnership cannot be publicly traded, and that the interest cannot be disposed of within two years of receipt. The typical carried interest, then, will find ample shelter in the proposed regulations. The interest has no current liquidation value; if the fund were liquidated immediately, all of the drawn-down capital would be returned to the LPs. And while the carried interest has value, it is not related to a “substantially certain and predictable stream of income from partnership assets.” On the contrary, the amount of carry is highly uncertain and unpredictable.23 Character. The tax law thus provides a significant timing benefit for GPs by allowing deferral on their compensation so long as the compensation is structured as a profits interest and not a capital interest in the partnership.24 But there is more than 16 See Diamond v. Commissioner, 492 F.2d 286, 291 (7th Cir. 1974); [add cite to tax court case]. 17 See Rev. Proc. 93-27, 1993-2 C.B. 343. 18 See id. See also Rev. Proc. 2001-43, 2001-2 C.B. 191 (holding that a profits interest that is not substantially vested does trigger a taxable event when restrictions lapse; recipients need not file protective 83(b) elections). 19 See Rev. Proc. 93-27, 1993-2 C.B. 343. 20 See id. 21 See id. 22 It seems likely that the Treasury has authority to issue the proposed regulations, although it could be argued that the proposed regulations, while consistent with subchapter K, conflict with the plain meaning and/or congressional mandate underlying section 83. 23 See Cunningham, 47 Tax. L. Rev 247, 252. 24 The net result is also more advantageous than parallel rules for executive compensation with corporate stock. See William R. Welke & Olga A. Loy, Compensating the Service Partner with Partnership Equity: Code § 83 and Other Issues, at 17 (“The treatment of SP’s receipt of a profits interest under Rev. Proc. 93-27 is significantly better than the treatment of an employee’s receipt of corporate stock. While the 8
  9. 9. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 timing at issue: by treating the carried interest as investment income rather than service income, the tax law allows the character of realized gains to be treated as capital gain rather than ordinary income. Compensation for services is normally treated as ordinary income. In the partnership context, deciding whether a payment is compensation for services or something else is a difficult issue when the recipient, like the GP here, is a partner in the partnership. Section 83 provides the general rule that property received in connection with the performance of services is income.25 There is little question that a partnership profits interest is property. A simple reading of section 83, then, suggests that the GP should be taxed immediately on the fair value of the carried interest. It is far from clear, however, that Congress intended this reading when it enacted section 83.26 Section 707 further addresses payments from a partnership to a partner. So long as the payment is made to the partner in its capacity as a partner (and not as an employee) and is determined by reference to the income of the partnership (i.e. is not guaranteed), then the payment will be respected as a payout of a distributable share of partnership income rather than salary.27 For tax purposes, then, the initial receipt of a profits interest is not a taxable event, and subsequent distributions will be respected as simple payouts of the distributable share of income. The tax law therefore treats the initial receipt of the carry as a non-event, and then treats later distributions of cash or securities under the terms of the carried interest as it would any other distributable share of income from a partnership. Because partnerships are pass-through entities, the character of the income is preserved as it is received by the partnership and distributed to the partners. With the notable exception of hedge funds economics of a profits interest can be approximated in the corporate context by giving investors preferred stock for most of their invested capital and selling investors and the employee "cheap" common stock, the employee will recognize OI under Code §83 equal to the excess of common stock’s FMV (not liquidation value) over the amount paid for such stock. In addition, if the common stock layer is too thin, there may be risk that value could be reallocated from the preferred stock to the common stock, creating additional OI for the employee. In contrast, in the partnership context, the fact that partners who provide capital are merely entitled to a return of their capital (but no yield) before SP shares in profits generally does not create an OI risk for SP. Because the partners providing capital are entitled to a return of their capital before SP is entitled to anything, SP’s interest is still a profits interest with a zero liquidation value.”) [Cite to 79 Taxes 94 (2001)]? 25 See IRC § 83(a). 26 Cite to legislative history from senate finance committee; Cunningham; but see NYSBA report. 27 Arguably, the initial receipt of the carried interest is better characterized as itself a guaranteed payment (as it is made before the partnership shows any profit or loss). See Cunningham, 47 Tax. L. Rev. 247, 267 (“Because the value of a partnership interest received by a service partner, whether capital or profits, invariably is dependent upon the anticipated income of the partnership, the mere fact that the right to reversion of the capital has been stripped from the interest does not convert the property interest represented by the profits interest into a distributive share of partnership income. Even though the value of a profits interest or capital interest cannot be determined without reference to partnership income, the property interest itself has a fixed value, and its transfer is a payment of a fixed amount (that is, a guaranteed payment), rather than a mere distributive share of partnership income. Clearly, subsequent allocations of profits, either under the undivided capital interest or under the bare profits interest, are distributive shares not subject to § 707, although the one time transfer of the interest itself is.”) 9
  10. 10. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 that actively trade securities, most private investment funds generate income by selling the stock of portfolio companies, which normally gives rise to long-term capital gain.28 Tax law thus carves a wide gap between the economics of the carried interest and its treatment for tax purposes. The receipt of carry is economically valuable at the outset, and it is received in exchange for services. Under a pure economic concept of income, the GP should pay tax upon receipt of the interest, take a basis in the carry, amortize the basis over time, and recognize further income or loss as the partnership makes or loses money. Instead, the tax law allows the GP to defer tax by treating the initial receipt of carry as a nonevent for tax purposes, and it then allows the GP to treat the receipt of distributions as capital gains rather than as ordinary income, notwithstanding the fact that the distributions are related to the GP’s performance of services for the partnership. Readers may note that I have so far left out a significant piece of the tax analysis: the treatment of the partnership (and thus the impact of these rules on the other partners). Treating the receipt of a profits interest by the GP as a nonevent for tax purposes might be good for the GP but bad for the LPs, as the partnership cannot take a deduction for the value of the interest paid to the GP, which in turn means that the LPs lose the benefit of that current deduction. If the GP and LPs have the same marginal rates, then the tax benefit to the GP would be perfectly offset by the tax detriment to the LPs. As discussed in more detail below, however, a large number of LPs are tax-exempt. Subject only to the limitation of the distorting effect on contract design, it becomes rational for fund lawyers to take full advantage of the gap between the economics of the carried interest and its treatment for tax purposes.29 B. Institutional Practices The most talented financial minds in the United States are as likely to be found in Greenwich, Connecticut or Sand Hill Road in Palo Alto as they are on Wall Street. The last two decades have seen investment funds explode in number. With each new fund comes another two and twenty structure. These institutional developments place new stress on partnership tax rules designed for more humble small businesses, not billion dollar hedge funds. In this Section, I discuss the institutional considerations that have changed the game and make reform of the partnership tax rules a more pressing concern. Tax Rate on Capital Gains. The increasing gap between the top rate on ordinary income and the top rate on long-term capital gains changes where we should focus our attention. [Insert chart]. When the Tax Law Review held a symposium on reforming subchapter K in 1992, the gap was only three percentage points. The gap is now twenty points. Assuming a six percent discount rate, conversion into long-term capital gain is worth about six years of deferral. [check math] 28 See § 1(h). Moreover, the venture fund’s investment in portfolio companies sometimes fit into the definition of “qualified small business stock,” reducing the tax rate even lower. See §§ 1202, 1045. 29 Given that a structure that maximizes benefits for both the GPs and a majority of LPs is probably best for all; for this and other reasons taxable LPs gravitate away from venture capital, creating a clientele effect. 10
  11. 11. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 Private Equity and Hedge Fund Boom. [add statistics showing boom in private equity and hedge funds. Institutional investors now have over a trillion dollars invested in hedge funds.] The Missing Preferred Return. Some private investment funds – in particular, many venture capital funds – fail to index the measurement of profits to an interest rate or industry benchmark. Some of the “profits” reported by these funds are more accurately characterized as reflecting the time value of money rather than true value added by the GP. Elsewhere I argue that this phenomenon is partly explained by tax considerations, as omitting a preferred return term allows the fund managers to accept lower management fees than they otherwise would, maximizing the tax advantage.30 Buyout funds and most other investment funds use a preferred return. Rather than a true preferred return, however, most use a hurdle rate. Thus, once a fund manager clears the hurdle, profits are allocated disproportionately to the GP until it catches up to the point where it would have been had it received twenty percent of the profits from the first dollar. Moral hazard concerns prevent funds from doing away with the preferred return entirely, particularly in funds where GPs could plausibly pursue a lower-risk, lower-return strategy than the LPs want. Still, by using a hurdle rate rather than a true preferred return, profits interests are larger than they would otherwise be, raising the stakes on the tax question. Whether the design of the preferred return is explained by tax motivations is a question I take up elsewhere. Regardless of whether the design is tax-motivated, there is no question that GPs are maximizing the amount of compensation they receive in carried interest, and there is no question that such distributions often give rise to long-term capital gain. Thus, even if one thinks that the design of preferred returns are wholly free from tax considerations, they raise considerations of distributional equity. Should the carried interest received by venture capitalists and hedge fund managers be thought of as labor income or investment income? If it is labor income, then how can one justify a lower tax rate? Portable Alpha. The growing adoption of “portable alpha” strategies increase demand for the services of private investment fund managers, increasing the amount of compensation they receive. Portable alpha is an investment strategy that emphasizes seeking out positive, risk-adjusted returns rather than simply managing risk through portfolio allocation. Modern portfolio theory cautions investors to maintain a diversified mix of stock, bonds, and cash, with perhaps a small amount of assets in alternative asset classes like real estate, venture capital, buyout funds and hedge funds. According to portable alpha proponents, institutional investors fool themselves into thinking that because they achieve high absolute returns, they are doing well. In reality, most of the return simply reflects a return for bearing market risk. What most institutional investors have amounts to little more than an expensive index fund. Portable alpha, by contrast, recognizes how difficult it is to find managers who can reliably create positive, risk- 30 See Victor Fleischer, The Missing Preferred Return, J. Corp. L. (forthcoming 2006). 11
  12. 12. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 adjusted returns. When alpha opportunities arise, they should be exploited fully; the remainder of the portfolio can be cheaply adjusted for any increase or decrease in beta. The search for alpha has increased as the markets have become more efficient (or, perhaps, as increasing numbers of portfolio managers recognize the markets to be efficient, or believe the markets to be efficient). Old-fashioned stock-picking is out. Instead, institutional investors seek alpha in alternative asset classes. Instead of a traditional long-only portfolio, an investor might invest half its assets in market-neutral long/short hedge funds. To increase market risk, then, the investor might enter into a forward contract or a series of option contracts on the S&P 500, thereby increasing beta. The availability of adjusting beta through the use of derivatives is what makes the alpha “portable.” (For a more complete discussion of portable alpha, see Exhibit A infra.) Alpha requires two inputs; the talent of the managers who can create it, and the capital of investors to implement the strategy. The two parties share the expected wealth between them, institutional investors are quite rationally willing to share large amounts of the profits for the fund managers who create them. As investment funds have grown, one might have expected the compensation remain relatively constant on an absolute basis and shrink on a percentage basis. Instead, as investors recognize the value of alpha and learn how to better exploit alpha through the use of derivatives, two and twenty remains the industry standard, leading to enormous gains in compensation on an absolute basis. The absence of substitute taxation. Portable alpha is important because it increases the demand for investment fund managers, thereby increasing their pay. But it’s also important because it changes the source of supply of investment capital. Among the early adopters of the portable alpha concept are pension funds, endowments, and other tax-exempt investors. Tax-exempts have long dominated the LP market for venture capital and buyout funds, and they are again leading the way as hedge funds go mainstream. The overwhelming presence of tax-exempt limited partners creates an opportunity for tax savings. Section 83 relies on substitute taxation to get us close to the right result. Consider your typical corporate executive who receives non-qualified stock options. Those stock options have economic value when they are received, yet the executive defers recognition until the options vest. This deferral is valuable to the executive. But it is costly to the employer, which must defer the corresponding deduction. Thus corporate equity compensation is not enormously tax-advantaged in the usual case.31 When the fund managers defer income and convert what ought to be ordinary income into capital gain, limited partners lose what may be a valuable deduction. If the limited partners are tax-exempt, however, they have no objection to losing the tax deduction.32 The benefits of deferral are strongest where there is a tax-indifferent counterparty, and tax-exempt LPs serve this role. 31 Corporate equity compensation is tax-advantaged if the corporation shorts its own stock to hedge the future obligation, see Walker; Miller & Scholes, or if the executive’s marginal tax rate is higher than the corporation’s marginal tax rate. 32 See Victor Fleischer, The Rational Exuberance of Structuring Venture Capital Start-Ups, Tax L Rev. 12
  13. 13. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 Sarbanes-Oxley. [Here I will describe the literature finding that more firms are going private as a response to Sarbanes-Oxley. This increases the demand for private equity.] 409A. The income tax does not immediately tax an unsecured, unfunded promise to pay. Employees may set aside funds in a trust – known as a rabbi trust – without running afoul of the constructive receipt doctrine, so long as the funds are exposed to the claims of creditors. Instead, employees are taxed when it is received (or when the trust is funded). For many years, corporate executives have been able to nominally defer compensation while enjoying the economic benefits of the compensation by effectively protecting funds from creditors. For example, some plans would provide for funding in the event that the company’s financial health deteriorated, thereby removing any real danger that the funds would be lost. In such an arrangement, the rabbi trust becomes an investment vehicle which allows the employees to invest with pre-tax dollars. Under section 409A, such aggressive planning would become create taxable income on receipt (rather than when the plan was funded later). Even under 409A, deferred compensation retains some tax advantage for corporate executives in many cases. Specifically, whenever the employer’s investment income is taxed at a lower rate than the employee’s investment income, or the employer is eligible for tax preferences for which the employee is not, deferring compensation may be advantageous.33 Still, 409A has changed the executive compensation landscape. Partnerships provide more tax planning opportunities than corporations. Whether tax planning affects the decision-making process of investment bankers considering making the jump to private equity is hard to say. And tax is just one of many regulatory areas where partnerships are favored over corporations.34 Disentangling the effect of taxes may be too much to ask, but if one seeks to minimize the distorting effect of tax by treating entities alike, 409A suggests that reforming the partnership rules should follow. Gamesmanship. Recall that while the carried interest can give rise to capital gains (depending on the character of the underlying partnership income), management fees give rise to ordinary income. Some GPs, recognizing the tax play, opt to reduce the management fee in exchange for an enhanced allocation of fund profits. The choice may be made up front during formation of the fund; in other cases the GP may reserve the right to periodically waive the management fee in exchange for an enhanced allocation of future fund profits.35 There is a trade-off between tax risk and entrepreneurial risk. So long as there is some economic risk that the GP may not receive sufficient allocations of future profit to 33 See Ethan Yale & Gregg D. Polsky, Reforming the Taxation of Deferred Compensation, at 7 (draft on file with the author). 34 Cite to Talley paper and other literature on going private transactions after Sarbanes-Oxley. 35 See Jack S. Levin, Structuring Venture Capital, Private Equity, and Entrepreneurial Transactions at 10-13 (2004 ed.). 13
  14. 14. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 make up for the foregone management fee, then most practitioners believe that the constructive receipt doctrine will not apply, and future distributions will be respected as distributions out of partnership profits.36 The entrepreneurial risk may be smaller than it appears at first glance, depending on the underlying portfolio of the fund. If the management fee is waived in favor an increased profit share in the following year, and the GP knows that an investment will be realized that is likely to generate sufficient profits, then the constructive receipt doctrine should arguably apply. To my knowledge, however, there is no published authority providing guidance on how much economic risk justifies deferral. [more on constructive receipt] Another way to understand the gamesmanship is from the perspective of a professional working for the GP. (Recall that the a handful of executives usually hold the equity in the GP.) By waiving management fees, the individual is buying into his own fund using pre-tax dollars. While undoubtedly exposing him to more investment risk than he might otherwise undertake, the tax benefits make the choice worthwhile. Moreover, he may be able to hedge the increased risk somewhat by making changes to rest of his individual investment portfolio. [add paragraph on shifting income offshore] Practitioners are, in sum, well aware of the tax advantages associated with a profits interest in a partnership, and they work aggressively to exploit the gap between the economics of the deal and its tax treatment. C. The Effect on Wall Street It is said that a hedge fund is a compensation scheme masquerading as an asset class. People who say this usually just mean that hedge fund managers are greedy. But what if we consider the notion a bit more seriously? What if the defining characteristic of hedge funds is the compensation scheme, not the underlying portfolio? Many hedge funds are like the proprietary trading desks of investment banks, only wrapped in a limited partnership shell. Others are like buyout funds (but move more quickly), which are also like the holding company of a conglomerate (but in a very different organizational form). Still others are like mutual funds, but with a different clientele. What all hedge funds have in common is the compensation scheme. Hedge funds are an efficient way for the most talented managers to extract out as much rent as they deserve (and maybe more). And because the human capital talent here is mobile (not tied to physical capital or even firm-specific capital), stars are free agents, able to move around or start a new fund, extracting most of the surplus they create from the investors who put up the financial capital. 36 Levin at 10-13; cite to Wilson Sonsini memos. 14
  15. 15. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 The tax and non-tax benefits of the two and twenty structure lures professionals away from investment banks and other corporations. The reasons for the shift in the labor market are complex, and tax affects this market only at the margins. But the margins matter: Corporations and investment funds compete with each other for talent., and the tax code puts corporations at a disadvantage.37 Wall Street traders who used to work in-house at investment banks or managing mutual funds increasingly work instead at hedge funds, competing against their former bosses. Buyout funds compete with public companies in the takeover market, sometimes working together in “club deals” or “consortium deals” to wield huge amounts of capital. Venture capital funds compete directly with Google, Yahoo and Microsoft for early stage technology companies. While it may seem hard to feel sorry for the likes of Goldman Sachs, Berkshire Hathaway, and Google, it is awfully hard to gin up a reason why the tax code should stack the deck against them. [more – conclude that neutrality between corporations and partnerships is probably a good idea] III. Deferral The concept that a service partner can receive a profits interest in a partnership without facing immediate tax on the grant does not sit well with most people’s intuitive sense of fair play. These profits interests, after all, have enormous economic value. A share of the GP stake in Kleiner Perkins newest fund would fetch top dollar. Tax Notes columnist Lee Sheppard thus characterizes the proposed regulations as a “massive giveaway.” As we shall see, however, there is broad academic agreement (along with the less surprising agreement among practitioners) that deferral is the right result, at least with respect to a profits interest received in exchange for future services. The underlying principle in support of deferral seems to be (1) a broadly-shared reluctance to taxing endowment and (2) the intuition that one should not be taxed currently on the value of self-created assets. Neither of these principles, when examined closely, necessarily precludes other timing solutions, such as accrual taxation or a special tax on distributions. A. Endowment Taxation and Enslaving the Beachcomber Whatever its appeal as an ideal tax base, few tax scholars are willing to support endowment taxation in the real world. Endowment taxation calls for taxing people based on their ability to earn income, regardless of whether they actually go out and earn the income. It would tax both realized and unrealized human capital. Its primary attraction 37 In response to labor market pressures, corporations have begun to set up side funds … See Berg & Serebransky paper. 15
  16. 16. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 as an ideal tax base is that by taxing wages regardless of whether the wages are actually earned, it reduces or eliminates the labor-leisure distortion and the deadweight loss that comes with it. There would no longer be a tax penalty for working. Scholars are deeply troubled by the realization doctrine when it comes to investment income. When it comes to labor income, however, the realization doctrine enjoys widespread support. Few scholars, if any, favor taxing the returns to labor income until the returns are actually realized. Scholars differ as to why we shouldn’t tax endowment – there are liberal objections, libertarian objections, and administrative objections. But the opposition to taxing endowment is overwhelming. [add discussion, cites from Hasen, Stark, Shaviro] The opposition to taxing unrealized human capital is reflected in subchapter K. Professor Rebecca Rudnick characterizes the principle as one of the four fundamental premises of partnership tax. I do not challenge that fundamental principle here. I question, however, whether that principle provides as strong a justification for the status quo treatment of a profits interest in a partnership as other believe. Specifically, one could eliminate deferral without taxing unrealized human capital through accrual taxation or through a special tax imposed after the fact on realized income. Cunningham. In a 1992 Tax Law Review article, Professor Laura Cunningham argues that there is no economic distinction between a capital interest and a profits interest that would justify taxing the two interests differently. Because the value of a profits interest, like the value of a capital interest, depends on the value and expected return of the partnership’s underlying assets, the distinction is without a difference. Treating one as “speculative” simply because it has no current liquidation value does not bring one closer to economic reality. As an example, Cunningham discusses a partnership that holds a single asset, a ten year bond with a face amount of $1000 bearing interest at the rate of 10% a year. The partnership hires a service partner, S, who receives (1) a 25% interest in both the profits and capital of the partnership, (2) a 65% interest in the partnership capital, but no profits interest, and (3) a 40% profits interest, but no capital. In each case, the current fair value of S’s interest is 25%. Yet the tax consequences differ markedly. This result, she argues, “ignores the economic reality that any given interest in a partnership is composed of some percentage of the partnership’s capital and the return on capital, or profits.” Separating the two conceptually, she continues, is a mistake. “The disaggregation of these components of the interest does not change the fact that each represents a significant portion of the value of the partnership’s assets.” Taxing one while not taxing the other, she concludes, has no apparent justification.38 Cunningham nonetheless ultimately agrees that with the status quo treatment of a partnership profits interest when the profits interest is granted in exchange for future services.39 The policy against taxation of unrealized human capital, she explains, “would dictate against taxation until realization occurs. Nothing in subchapter K changes this 38 Cunningham, supra note 1, at 256. 16
  17. 17. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 result: In fact, subchapter K arguably was intended to encourage just this type of pooling of labor and capital by staying current tax consequences until the partnership itself realizes gross income.” Cunningham would therefore limit immediate taxation to cases in which the service partner completed all or substantially all of the services to be rendered at the time it receives its interest in the partnership. For Cunningham, then the relevant question is whether the partnership interest was received for past or for future services. If the former, then it ought to be taxed currently, regardless of whether it is characterized as a profits interest or a capital interest. If the latter, then current taxation would violate realization principles, and a wait-and-see approach is proper. [Add paragraph on Rudnick.] B. Sweat Equity and Taxing the House that Jack Built The second principle that is invoked to defend the status quo is the principle that one generally not taxed on wealth in the form of self-created assets.40 If you dig a vegetable garden in your backyard, you are not taxed on the tomatoes. If you build a bobsled in your backyard shed, you are not taxed when it is completed. You are only taxed if and when you sell it to the Jamaican Bobsled team. This idea arguably extends from the individual to the partnership context, as Professor Laura Cunningham notes. As a general matter, Cunningham explains, a partnership is treated as an aggregate of its members for purposes of determining the tax liability of the partners. Aggregate treatment generally dictates that an individual be taxed identically whether the business is operated in partnership form or as a sole proprietorship.41 [add discussion from Rudnick] Schmolka. Professor Leo Schmolka focuses on the pooling of labor and capital in a partnership, extending the idea that one should not be taxed on the creation of self- created assets to the partnership context. To be more precise, this is an argument that one should not be taxed on the creation of partnership-created assets. One should be taxed only on the income that those assets actually generate. Schmolka’s analysis leads him to argue that we need only ask one question: Were the services rendered in one’s capacity as a partner? If one acts as a partner (and not as an employee or independent contractor) then one ought to be allowed to enjoy the benefits of subchapter K. Schmolka stresses that the tax law draws distinctions 39 See Cunningham, supra note 1, at 260 (“Where the profits interest is granted in anticipation of services to be rendered in the future, … taxation of the interest on receipt would violate the realization requirement and the policy against taxing human capital. This would be inconsistent with the basic purpose and structure of subchapter K.”) 40 See Gergen, supra note 1, at 79; Noel Cunningham & Deborah H. Schenk, How to Tax the House that Jack Built, 43 Tax L. Rev. 447 (1988). 41 See Cunningham, supra note 1, at 259. 17
  18. 18. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 analogous to the capital/profits interest distinction all the time, whenever it draws a line between property and income from property. For example, the transfer of a term interest in property yields different tax consequences than a remainder interest.42 The coupon stripping rules of section 1286, he asserts, “mark the only instance of congressional abandonment of this judicially developed distinction between property and income from property.”43 If one insists on recognizing the economic value of a profits interest, Schmolka argues, then the proper economic analogy is to section 7872, which governs compensation-related and other below-market interest rate loans. Cunningham’s central premise, he argues, is that a naked profits interest shifts the use of capital for an indefinite period to the service partner. “Economically,” Schmolka argues, “that temporary [capital] shift is the equivalent of an interest-free, compensatory demand loan.” The service partner is compensated through the use of the other partners’ money. Schmolka concludes, therefore, that section 7872 principles ought to apply. Section 7872 would force service partners to recognize ordinary income for the forgone interest payments on the deemed loan; if the deemed loan had an indefinite maturity, then the rules would demand this interest payment on an annual basis so long as the “loan” remained outstanding. Schmolka notes that subchapter K comes awfully close to this result by looking to actual partnership income (the income produced by the constructive loan) rather than using a market interest rate for lack of a better proxy. So long as the service partner’s services are rendered as a partner and not as an employee, nothing beyond subchapter K. C. Sweat Deferral? I question whether Schmolka’s section 7872 analogy is worth the candle. Imagining forgone deemed interest on a constructive demand loan requires conceptual leaps even beyond the average tax lawyer’s level of comfort. Schmolka is certainly right that there is compensation involved when the GP gets to use other people’s money to make investments in which it takes a share of the profits. His more controversial argument is that subchapter K already accounts for the capital shift by forcing the taxable income to follow the economic income that is ultimately allocated to the service partner. Professor Schmolka glosses over the important distinction between 7872 and subchapter K – the deferral and conversion available under subchapter K. Under 7872, the service partner would recognize ordinary income at a market rate of interest on an annual basis. Under subchapter K, the service partner does not recognize income until the partnership recognizes income. Moreover, when the service partner recognizes income, the character is determined at the partnership level. Schmolka does not find the distinction important: “The only difference is that section 7872 looks to the applicable federal rate as the value of the use of money, whereas subchapter K looks to the actual distributive shares of the partners as the measure of their respective participation in the 42 See Schmolka, supra note 1, at 289. 43 See Schmolka, supra note 1, at 291 n.20. 18
  19. 19. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 partnership’s activities[.]”44 So long as the GP’s services are rendered as a partner, he concludes, “nothing beyond subchapter K is needed.”45 The changing institutional practices discussed in section II above, however, take Schmolka’s 7872 analogy to a different logical conclusion. Subchapter K allows deferral in contexts beyond that which Congress could have imagined when it was enacted. The 7872 analogy provides an intermediate solution that addresses deferral without running afoul of the no-endowment-taxation principle. If service partners are treated as holding a constructive loan, then we can treat them as owing interest to the LPs. When that deemed interest is deemed forgiven, they owe income tax on that deemed compensation. As such, on an annual basis, the GP would realize income equal to a market rate of interest times the amount of committed capital. Assuming a market rate of eight percent interest, the GP of a billion dollar hedge fund would receive ordinary income of 80 million dollars. [This is then followed by a deemed recontribution to the fund, which increases the capital account of the GP.] For all its complexity, this approach amounts to nothing more than accrual taxation of deferred compensation. Professor Michael Doran has argued that accrual taxation is the right approach in the corporate context. [add Yale & Polsky discussion] As a practical matter, accrual taxation would make more sense for some funds than others, and unfortunately it would work best for the funds where the solution is least needed. Accrual would necessitate tax distributions to the GPs. In illiquid funds like venture capital funds, LPs would be asked to make capital contributions just to fund tax distributions, long before they realize any income. Accrual taxation would work well for liquid funds, like many hedge funds. But such funds already generate income on an annual basis through their frequent realization of gains and losses.46 Alternatively, we could impose a special surtax after the fact to account for deferral, as Professor Daniel Halperin has advocated in the corporate context. [Add discussion from Yale & Polsky.] [add paragraph on the need for consistency between corporate and partnership regimes] In sum, there is no easy solution to the deferral problem. The good news, such as it is, is that there’s no easy solution in the corporate context either. The proper normative goal, then, may be to aim for consistency between the corporate and partnership regimes. Even under 409A, it’s possible to defer income so long as the compensation takes the 44 Schmolka, supra note 1, at 307. 45 Schmolka, supra note 1, at 308. 46 [Some hedge funds operate much like the proprietary desks of investment banks, which are mark-to- market. Those hedge funds could elect mark-to-market treatment (?).] 19
  20. 20. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 form of an unfunded, unsecured promise to pay. A carried interest easily clears this hurdle. And so deferral, while still a bitter pill, is more easily swallowed. IV. Sweat Equity Tax scholars generally agree that labor income should be taxed at progressive rates. One largely overlooked anomaly in the system in the concept of sweat equity. Sweat equity, as I define it here, is the notion that one should not be taxed at ordinary income rates on the labor income which is converted into a self-created capital asset. Imagine an immigrant grocer who borrows $100,000, uses the money to open a grocery store, and ultimately pays down the debt and sells the store to a chain three years later. Conceptually, the grocer should be taxed at ordinary income rates, followed by a recontribution of that capital (the human capital now converted into investment capital) back into the business, giving him a cost basis in the business. Instead, under current law, the self-created asset is given a zero cost basis and any gain will be treated as long- term capital gain. I choose the example of an immigrant grocer intentionally, of course. The concept of sweat equity accords with a stubborn intuition that one should be permitted to convert one’s labor income into one’s own equity without being taxed on the conversion. Allowing these rules to apply in the context of private investment funds, however, takes the quaint notion of sweat equity a bit too far. If the point is to subsidize entrepreneurial activity, then the subsidy can be targeted more carefully. A. Below-Market Salary and Conversion Entrepreneurs often give up stable jobs when they start their own companies. As founders, they often pay themselves below-market salaries while they build up the business; the savings are reflected in the appreciation of their equity. The proper tax consequences, from an economic perspective, would have the founder report ordinary income on a market rate of salary, followed by a deemed contribution of capital of the difference between the market rate of salary and the actual rate of salary. Instead, the low salary is generally accepted for tax purposes, and the appreciation is taxed later, at capital gains rates. [The case for sweat equity is the strongest in the small business context where valuation is most difficult and liquidity is a problem. The case is weaker in the investment fund context.] [Discuss sweat equity as subsidy. If subsidizing small business is the point, however, it’s not clear that the subsidy is targeted well.] 20
  21. 21. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 [With labor income, there is also broad consensus among tax scholars (if not the general public) that when labor income is realized, it ought to be taxed at progressive rates. The status quo for taxing partnership profits interests violates these broadly held beliefs.] B. Compensating Service Partners Sweat equity is a quaint notion that should not be applied to the investment fund context. Fixing the problem requires fundamental reform of the way that we treat partners who provide services to the partnership. Professor Mark Gergen, in a 1992 Article in the Tax Law Review, outlines the necessary reforms. Gergen’s approach is relatively simple. It does not change the status quo with respect to realization. A grant of a profits interest in a partnership, in and of itself, would not give rise to taxable income. When compensatory allocations are made, however, they would be treated as salary paid by the partnership. The allocation would be income to the recipient and the partnership would deduct or capitalize the expense. Gergen argues that the decision not to tax the exchange of a profits interest for services “arguably compels” taxing allocations of profits as compensation. Otherwise, he argues, partners enjoy “extraordinary privileges” not available to service providers in other contexts. If the partnership’s income is not service-based, the service partners do not pay social security tax. They never pay tax at ordinary rates if the allocations represent capital gain, or if they sell their profits interest to a third party or sell it back to the partnership. If they receive in-kind compensation, they may pay no tax at all. Gergen’s arguments apply with special force in the investment fund context. Fund profits arise from the realization of investments, not services, so GPs indeed avoid paying any social security tax. The realization of investments often gives rise to capital gain. And GPs sometimes receive distributions in-kind. [Give Kleiner Perkins – Google example. The GP can take a distribution in kind and avoid paying tax on the distribution. The GP can borrow against the stock or set up a collar. If the stock is eventually sold, only then does the GP pay any tax, and at a reduced LTCG rate. And if he passes along the stock to his heirs, the heirs receive the stock with a stepped up basis.] Gergen acknowledges that the measurement of income is imperfect. But it is the best that we can do absent some form of accrual taxation. “These changes measure the income of service partners and other partners,” he explains, “as well as it can be measured given the current rules on deferred compensation and capitalization outside of subchapter K.” Importantly, the proposal would not discourage innovative compensation arrangements; by making the tax consequences follow the economics more closely, the proposal would reduce distortions. 21
  22. 22. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 [Drawback of the proposal: difficulties identifying compensatory allocations.] [Add paragraph considering whether the approach is consistent with the fundamental premises of partnership taxation (Rudnick).] [One drawback of the reform is that while it would narrow the gap between partnership equity and corporate equity, it would widen the gap between partnership equity and equity in a sole proprietorship.] [The trade-off is ultimately one between seeking consistency with sole proprietorships or corporations. As partnerships increasingly resemble corporations, the latter is the wiser course to follow.] V. Conclusion I have argued that changes in the institutional practices of investing warrant reform of the rules governing the taxation of a profits interest in a partnership. Not every gap between the economics of a profits interest and its tax treatment must be eliminated. Until the time comes when we fundamentally reform deferred compensation in other contexts, consistency may be the proper goal.47 The granting of a profits interest in a partnership should not be treated as a taxable event. When those allocations of profits eventually arrive, however, they should be treated as compensation, not investment income, and taxed as ordinary income and not capital gain. 47 This Article has assumed that the underlying normative goal is to have consistently applied income tax. It is worth a few words discussing the problem if this is not the case. What if, instead of an income tax, a consumption tax base is the ideal? Even under a consumption tax base, reform is needed. Most consumption tax proposals allow either yield-exemption or a deduction for savings. In either case, however, it is assumed that wages will be taxed at progressive rates. And so it is crucial to maintain a line between service income, which will be taxed at progressive rates, and investment income, which will be taxed at low rates or not at all. By allowing conversion of labor income into investment income, the status quo treatment of a profits interest in a partnership presents a tempting loophole under a consumption tax. 22
  23. 23. FLEISCHER, “TWO AND TWENTY” UCLA DRAFT, FEB 2006 Appendix A Note on Portable Alpha Consider two investors, Betty and Bethany. Each determines that they want a portfolio allocation of 70% in a diversified stock portfolio, 20% in a diversified bond portfolio, and 10% in cash. Betty believes that good money managers can beat the market by picking stocks. So she allocates her 70% equity allocation among several mutual fund managers. Bethany shares Betty’s belief in the markets, but she believes that markets are efficient (at least in the semi-strong form), and she has read the research indicating that mutual fund managers rarely make up for the fees they charge. Instead of choosing among mutual fund managers, Bethany invests in a passive index fund, thereby saving on fees. Both Betty and Bethany derive returns from bearing market-risk, or beta. Now imagine a third investor, Al, who also wants a portfolio allocation of 70% equity, 20% debt, and 10% cash. Al shares Bethany’s belief in efficient markets, but takes it one step further by seeking alpha. Al notes that certain venture capital funds, buyout funds, and hedge funds achieve positive returns in a wide variety of market conditions. Al secures admission to a few of these funds, taking capital away from the amount he would have allocated to equity. But Al is still willing to bear the same level of market risk (beta) as before. Thus, on top of the remaining half of the equity allocation, he might also enter into a forward contract on the S&P 500, increasing his beta back to where it was before. . The basic insight is that of beta is what really drives returns, then investors can acquire the desired level of market risk more cheaply through derivatives, which require less commitment of capital. Beta is cheap and easy to find. What is more difficult to find is alpha, or positive risk-adjusted returns. When an investor finds a source of positive, risk-adjusted returns, then that opportunity should be exploited, and the investor should other transactions in the portfolio to balance out the risk (or increase the risk, as appropriate). Once a fringe strategy, portable alpha has entered the mainstream. Consider the portfolio of the Yale endowment. [describe shift to 50% in alternative assets]. 23