Thursday, March 2, 2006
Victor Fleischer (UCLA) presents Two and Twenty: Partnership Profits in Hedge Funds, Venture Capital Funds, and Private Equity at UCLA today as part of its Tax Policy and Public Finance Workshop Series, moderated by Vic and Eric Zolt. Here is the abstract:
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 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.
The colloquium takes place in Room 2448, UCLA Law School, 4:00 - 6:00 p.m. PST.