July 30, 2007
Weisbach: Don't Change Tax Treatment of Carried Interests in Private Equity Partnerships
David Weisbach (Chicago) has submitted a 17-page research report, The Taxation of Carried Interests In Private Equity Partnerships, to members of Congress. The study was funded by the Private Equity Council. Here is the Executive Summary:
Holders of carried interests in private equity partnerships (as well as all other partnerships) are taxed on their share of partnership income. If the partnership has long-term capital gain, holders of carried interests are taxed on their shares of the long-term capital gain. Some have raised the argument that this “pass-through” treatment of capital gains income from carried interests creates an anomaly because the sponsors of private equity funds perform services for the partnership, and most service income is taxed as ordinary income. They have, therefore, proposed taxing income from carried interests in private equity partnerships as ordinary income.
These proposals are not consistent with basic principles of the tax law, including how capital gains are defined and how partnerships are taxed. They are misplaced for two reasons.
First, the labor involved in private equity investments is the same type of labor intrinsic to any investment or entrepreneurial activity. Private equity sponsors select the investments, arrange the financing, exercise control rights inherent in ownership of the portfolio companies, and eventually decide when to dispose of the assets. If the performance of these tasks were sufficient to deprive sponsors of capital gains treatment, capital gains treatment would not be available to any investor. For example, purchasing stock through a margin account involves combining capital, some portion of which is provided by third parties, and labor effort to make an investment. Even though much of the value may be created by the efforts of the investor to identify good stocks or other investments, the investor gets capital gains treatment. Similarly, entrepreneurs who use their ideas and efforts to form a company, are taxed at capital gains rates when they sell the company. For example, a founder of a company may contribute ideas and labor to create value and gets capital gains treatment when he sells the stock.
Private equity activity is very much like a combination of investment and entrepreneurship: it combines skill and effort to choose investments, restructure the company, and create value. The only difference is that private equity funds use limited partnership interests instead of debt to finance their activities. It is not a good idea, however, to change the treatment of private equity funds based on how they finance their activities or because they use a partnership. The long history of partnership tax rules shows that taxing partners differently than they would be taxed if they engaged in partnership activity directly is not wise.
Second, even if there were good reasons for changing the tax treatment of carried interests, the change would be complex and avoidable, imposing costs on all involved without raising any significant revenue. Any rule treating payments on carried interests as service income would require taxpayers and the government to accurately separate labor and capital income, a task which has proven difficult in other contexts. Any such rules would impose enormous complexity on the system. Moreover, because any rules would depend entirely on the use of a partnership structure instead of debt financing, they would be easily avoidable. The result would be less efficient economic structures and little or no change in tax revenues.
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The most important sentence in the whole essay appears at the bottom of page 6: "Unfortunately, there is little if any conceptual clarity governing the distinction between capital gains and ordinary income."
Right. Because (as the essay confirms, though while making a different point), in general a business may be structured to return either income or capital gains to investors. So no one can draw a useful distinction between income and capital gains and that was recognized in the 1986 tax reform. In fact, the reduced tax rates for "capital gains" which have since crept back into the revenue code are best understood as returns to successful rent-seeking by big investors. Since wage earners and interest recipients lack political clout, they must pay the higher "ordinary income" tax rates.
Anyway, the folks who persuaded Congress to quietly give them special tax breaks must now contend with counter-pressure from people who do have some clout and who (quite rightly) envy those breaks (e.g., lawyers, who don't get to treat their contingent income as capital gains the way investment-partnership GP's do). Rent-seeking is a tough job that never ends-- investment-partnership GP's have pulled "above market returns" out of Congress as well as Wall Street, but the competition is coming up fast.
Weisbach's essay makes some arguments against taxing investment- partnership GP's contingent income like everyone else's. The argument that changing the rules would be unfair provokes the opposite of sympathy-- the current rules are unfair, so changing them would be simple justice. The argument that changing the rules would provoke complex, even wasteful, restructuring of investment-partnership deals is artful misdirection-- to accept it the reader must assume (as the writer wishes him to) that preferred tax treatment for GP's gains is desirable, so we should try to provide it with minimum paperwork and overhead. The real conclusion to be drawn lies in a different direction: we should eliminate all of that paperwork and overhead by the simple expedient of taxing all income at the same rate (or according to the same schedule of rates).
(And for what it's worth, I think the essay glosses over a problem GP's would face if they borrowed instead of selling LP's. If the GP's borrowed they would take on actual risk, since they would have to pay back the loans or pay income tax on forgiven debts. I may be wrong about this, because there may be some (evil) loophole I don't understand which would relieve them of that risk.)
 Only larger investors are free to demand their investment income in the least-taxed form, whether cap-gains or interest. Small investors are necessarily risk-averse and in need of middlemen (generally, banks) to pool investments and manage them, so their return to investment nearly always appears in the form of interest. Even if you thought so-called capital gains should be favorably taxed to encourage investment, you could not logically deny the same tax treatment to interest income which is equally a return on investment.
Posted by: Mark Seecof | Jul 30, 2007 8:58:18 PM
It is said that "the reduced tax rates for 'capital gains' which have since [the 1986 TRA] crept back into the revenue code are best understood as returns to successful rent-seeking by big investors." Not at all. Reduced capital gains tax rates have "crept" back into the IRC because Congress has lacked the political will to keep the bargain it struck with the electorate in 1986 -- a lower maximum income tax rate spread over a broader tax base. Kick the top rate up to 39.6% and capital gains "preferences" will flourish like flies on horses. Elementary economics, folks.
Posted by: Jake | Jul 30, 2007 9:22:26 PM
Gee, I'm surprised, Paul, that you didn't have "Breaking News" in red flashing letters at the top of the page. Who would have thought the Private Equity Council would come out against increasing taxes imposed on private equity partnerships?
Are there any 17 page research reports out there written by someone who doesn't have a financial interest in the outcome of this debate? (I would have said, 'who doesn't have a dog in this fight' but Michael Vick has ruined used of that metaphor for at least several weeks.)
Posted by: W P Brown | Jul 30, 2007 10:32:42 PM