EFTA01119567.pdf

NOT ALL CARRIES. INTERESTS ARE CREATED EQUAL 6/10/20396:53:7-5 PM Not All Carried Interests Are Created Equal Adam H. Rosenzweig' Abstract Recently, a significant debate over the taxation of so-called "carried interest" in private equity funds has received much attention from scholars, the government, commentators, and the media. This debate has focused on whether private equityfiord managers who earn a percentage of the returns generated by the fund should be entitled to preferential "capital gain" treatment on such returns. The primary concern in this debate revolves around whether managers are effectively being compensated for services normally taxed at higher rates while receiving the benefit of preferential rates reserved for capital gains. Proponents of reform point to the services being performed by the managers, while proponents of the current system point to the investment exposure to the underlying assets of the fund. In reality, however, both sides are partially correct: carried interest is "blended" in that it represents both a return to services and a return on capital. Since carried interest is blended in this manner, an analogy to either proves less than satisfying. The issue of blended labor/investment returns is not new to the tar laws, however. Historically. one way the law has attempted to address the issue was not by deconstructing such returns into constituent parts, but instead by imposing a "holding period" requirement. Under this approach, not all capital investments are created equal; rather, only capital investments held for art arbitrary period of time while bearing the risk of loss qualify for preferential rates. The current debate over the titration of carried interest in private equity has failed to incorporate this element into the analysis, i.e., the role that holding period plays in denying preferential rates to blended labor/investment returns, such as carried interest. This Article will do so, concluding that, to the extent any reform of the taxation of carried interest within the existing framework of the income tax is appropriate, a better approach may be through the application of the holding period rules rather than through current proposals to either change the definition of capital gains or further complicate the partnership tax rules. Associate Professor and 2008-2009 Israel Treiman Faculty Fellow. Washington University School of Law. I would like to thank Cheryl Block. Bradley Borden. Victor Fleischer. Mark Gergen. Henry Ordower. Gregg Polsky, Philip Postlewaite. Robert Wootton. and the participants at the Washburn University Tax Colloquium for their helpful comments on previous drafts of this paper. I would also like to thank the organizers of. and participants in. 713 Electronic copy available at: http:,vssrn.corrilabstract=1 315004 EFTA01119567 NOT ALL CARRIES. INTERESTS ARE CREATED EQUAL 6/102009 6:530.5 PM Northwestern Journal of International Law & Business 29:713 (2009) i. INTRODUCTION Recently, a significant debate over the taxation of so-called "carried interest" in private equity funds has received much attention from scholars, the government, commentators, and the media—both within and without the United States.' This debate has focused on the treatment of carried interest as capital gain for the managers of private equity funds. In particular, it has focused on whether private equity fund managers who earn a percentage (typically twenty percent) of the gains generated by the investments held by the fund should be entitled to capital gain treatment (entitled to preferential tax rates) rather than ordinary income treatment on such largesse. The debate has generally been comprised of two separate but related points: (1) whether carried interest is properly analogized to "sweat equity"—that is, return on entrepreneurial effort—or salary (in this case, compensation for money management),2 and (2) if so, whether the tax rules applicable to partnerships are the proper fora for addressing this issue.3 Often overlooked in this debate is that the tax treatment of managers of different types of private investment funds, including not only private the Symposium. Any errors are solely those of the author. 3 See• e.g., JOINT COMM. ON TAXATION, PRESENT LAW AND ANALYSIS RELATING TO TAX TREATNIENT OF PARTNERSHIP CARRIED INTERESTS 6 (2007) [hereinafter JCT CARRIED INTEREST REPORT]; Bradley T. Borden. Profits-Only Partnership Interests. 74 BROOK. L. REV. (forthcoming 2009); Noel B. Cunningham & Mitchell L. Engler, The Carried Interest Controversy: Let's Not Get Carried Away, 61 TAx L. REV. 121; Victor Fleischer, Two and Twenty: Taxing Partnership Profits in Private Equity Funds. 83 N.Y.U. L. REV. I (2008): Matthew A. Melone. Success Breeds Discontent: Reforming the Taxation of Carried Interests: Forcing a Square Peg into a Round Hole, 46 DUQ. L REv. 421 (2008); Philip F. Postlevraite, Fifteen and Thirty Five: Class Warfare in Subchapter K of the Internal Revenue Code: The Taxation of Human Capital Upon the Receipt of a Proprietary Interest in a Business Enterprise, 28 VA. TAx REV. (forthcoming 2009): David A. Weisbach, The Taxation of Carried Interests in Private Equity. 94 VA. L. REV. 715 (2008): New Worries About Private Equity. ECONONIIST, June 23. 2007• at 63: Robert Peston. Tax and Private Equity, BBC. June 15. 2007. hnp://www.bbc.co.uldblogshhereponerstroberipeston/2007/06 ltax_and_private_equity.html ("in the UK. MPs ... are sending out a strong signal that they want private equity firms' carry'—their share of the capital gains made on the investments made by their funds—taxed at a higher rate than the prevailing 10%."); Howard E. Abrams. Carried Interests: The Past Is Prologue (Emory U. Law & Econ. Research Paper Series. No. 08-32). available at http://papers.ssm.com/sol3/papers.cfm7abstract_id=1085582. 2 Sweat equity is often thought of in terms of small business owners whose work effort increases the value of the business, which can then be sold for capital gain. Chris William Sanchirico, Taxing Carried Interest: The Problematic Analogy to "Sweat Equity•." 117 TAX NOTES 239.240-42 (2077). s See Postlewaite, supra note 1: Abrams. supra note 1. at I: see also Howard E. Abrams. Taxation of Carried Interests. 116 TAX NOTES 183 (2007). In addition, another related but distinct issue recently discussed in the literature has been the "conversion" of management fees into carried interest. See Gregg D. Polsky, Private Equity• Management Fee Conversions. 122 TAX NOTES 743 (2009). 714 Electronic copy available at: http:,vssrn.corrilabstract=1315004 EFTA01119568 NOT ALL CARRIES. INTERESTS ARE CREATED EQUAL 6/10/2009 6:53:25 PM Not All CarriedInterests Are Created Equal 29:713 (2009) equity funds but also venture capital and hedge funds, is not necessarily the same. The debate has tended to group these funds together, mostly because the managers of each tend to charge some form of percentage fee based on the performance of the fund (the so-called "two and twenty").4 Each is significantly different, however, not only in its business model but also in its tax treatment. Most notably, the tax treatment of the equivalent of carried interest in most hedge funds raises little of the same preferential rate concerns that plague carried interests in private equity funds, precisely because even under current law the profits paid to hedge fund managers are generally not entitled to preferential rates. The question that follows is: if the concern is over preferential rates for carried interest, why is there such a problem with the taxation of carried interest for private equity but not for other private funds? This Article contends that the answer lies in the failure of the carried interest debate to incorporate a crucial element into the analysis, i.e., the role that the holding period plays in denying preferential tax rates to blended labor/investment returns such as carried interest. The primary concern over the taxation of carried interest is that managers are effectively being compensated for their services but are receiving the benefit of the preferential rates applied to long-term capital gains. On the other hand, managers do have some investment exposure to the underlying capital asset. Thus, since carried interest is "blended'—it has some components of ordinary income and some components of capital gain—an analogy to either situation proves less than satisfying. The issue of blended labor/investment returns is not new to the tax laws, however. Historically, one way the law has attempted to address the issue was not by deconstructing such returns into constituent parts, but by imposing a "holding period" requirement.5 Under this approach, not all investments are created equal; rather, only capital investments held for an arbitrary period of time while bearing the risk of loss qualify for preferential rates. It is precisely these rules that prevent managers of certain private funds, such as hedge funds, from obtaining the benefit of preferential capital gains tax rates for their carried interest in most instances. In other words, not all carried interests are created equal. This Article will incorporate the holding period analysis into the carried interest debate, concluding that, to the extent any reform of the taxation of carried interest is appropriate (absent complete overhaul of the taxation of partnerships, repeal of the capital gains preference, or other fundamental change to the tax laws), the proper approach may well be Recent work has begun to emphasize these differences in other contexts. however. See Thomas J. Brennan & Karl S. Okamoto. Measuring the Tax Subsidy in Private Equity and Hedge Fund Compensation. 60 HAs-rims L.J. 27 (2008). 5 See infra Section IV. 715 Electronic copy available at: http:,vssrn.corrilabstract=1315004 EFTA01119569 NOT ALL CARRIED INTERESTS ARE CRFAlED EQUAL 6110/20119 6:530.5 PM Northwestern Journal of International Law & Business 29:713 (2009) through the holding period rules rather than current proposals to either change the definition of capital gains or further complicate the partnership tax accounting rules. Not only would this more closely conform with the historical approach to blended returns and capital gains, and more closely fit within the existing tax regime, but it could also be less problematic than other current proposals with respect to incentives for private equity funds (or their managers) to move offshore to escape U.S. taxation altogether. As a result, the holding period approach could bridge the divide between two sides of a debate which have often talked past each other: reformers who want to impose higher rates on carried interest and those who note reform could cause more harm than good under the current structure of the income tax. Section II of this Article will briefly summarize the structure of private equity and hedge funds and compare and contrast the carried interest in private equity and incentive fees in hedge funds so as to frame the role holding period plays. Section III will then summarize the current debate over carried interest, and discuss how current law applies to hedge funds to deny preferential rates. Section IV will analyze the policy behind the holding period requirement for long-term capital gains and explain why, as a normative matter, carried interest could be treated as short-term capital gain within this framework, both from a domestic and international standpoint. Section V will then discuss why, as a positive matter, the holding period approach would be an easier, more administrable means to address the concern over the taxation of carried interest under current law than other proposals. II. THE STRUCTURE OF PRIVATE EQUITY AND HEDGE FUNDS Much has been written on carried interest and the structure and business model of private equity funds. This Article will not attempt to recreate such discussions in detail, but rather will briefly describe the structure of private equity funds for the purposes of comparing and contrasting them with hedge funds, thus framing the role that holding period plays in denying preferential rates to blended returns. Both private equity and hedge funds are forms of private investment funds, or pools of money brought together in a non-regulated entity to make investments on behalf of the investors. All private investment funds share certain fundamental similarities: they raise money privately rather than through the public capital markets, the money is pooled and invested by managers who attempt to earn returns in excess of the market as a whole, and the managers charge a fee equal to a percentage of the gains generated on the investments.6 Beyond these similarities, however, different types of 6 See JCT CARRIED INTEREST REPORT. supra note I. at 34-36. 716 EFTA01119570 NOT ALL CARRIES. INTERESTS ARE CREATED EQUAL 6/10/2009 6:53:25 PM Not All CarriedInterests Are Created Equal 29:713(2009) private investment funds can differ significantly from an economic, business model, and tax perspective. Private equity funds are generally those funds for which the business model is to use leverage to acquire controlling interests in portfolio companies, and to increase their value for the purpose of a future sale! The increase in value may result from several reasons, including a more efficient capital structure, a more efficient management team, a better compensation structure, or simply through operating synergies or other more traditional strategic business models. Regardless, the intent of the private equity fund is to acquire control of a portfolio company, increase its value, and then monetize the investment within a relatively short time-frame, typically one to five years from the time of acquisition.8 Hedge funds, on the other hand, are less well-defined. Hedge funds are often referred to as lightly regulated pools of investment capital.9 This definition misses the crucial defining characteristic of hedge funds, however: hedge funds are those private investment funds which seek to exploit small arbitrage or mispricing opportunities in the market, and to profit from them through the use of leverage.10 Thus, rather than acquire controlling interests in companies, hedge funds engage in numerous investment activities such as trading of securities and derivatives, betting on the arbitrage of a proposed merger, providing liquidity to capital markets, or exploiting unperceived market arbitrages." Regardless of the particular business model, hedge funds do not, as a general matter, profit from acquiring controlling interests in companies with the intent to create excess returns through implementing changes in the particular company.12 As a result, hedge funds rarely hold investments for more than a short period of time or with any significant exposure to long-term price fluctuations. 7 Id. at 34. See Fleischer. supra note I. at 8-9. 9 See, e.g.. HEDGE FUNDS. LEVERAGE, AND THE. LESSONS OF LONG-TERNI CAPITAL MANAGEMENT: REPORT OF THE PRESIDENT'S WORKING GROUP ON FINANCIAL MARKETS (1999). available at hup://www.ustreas.gov/pressireleasesfreponsihedgfund.pdf: t. MONETARY FUND. GLOBAL FINANCIAL STABILITY REPORT: MARKET DEVELOPMENTS AND ISSUES (Sept. 2004) [hereinafter GLOBAL FINANCIAL STABILITY REPORT]; SEC STAFF REP.. IMPLICATIONS OF THE GROWTH OF HEDGE FUNDS (Sept. 2003). available at hup://www.sec.govinews/studies/hedgefunds0903.pdf. 10 Weisbach. supra note I. at 726. See generally Rene M. Stulz. Hedge Funds: Past. Present and Future, 19 (Fisher C. Bus. Working Paper Series. No. 2007-03-003. 2007), available at hup://www.ssm.com/abstract=93%29 (- The skill of a hedge fund manager is required to produce alpha returns. but not to take beta risk."). " See Henry Ordower. Demystifying Hedge Funds: A Design Primer. 7 U.C. DAVIS Bus. LJ. 323. 366-70 (2007) (discussing investment policies and objectives of. and use of leverage by. hedge funds). 12 See Weisbach. supra note I. at 726; Andrew W. Needham & Christian Brause. Hedge Funds. 736 TAX Munn.. A-1. A-7 (2007). 717 EFTA01119571 NOT ALL CARRIES. INTERESTS ARE CREATED EQUAL 6/10/2009 6:530.5 PM Northwestern Journal of International Law & Business 29:713 (2009) The typical private equity fund is formed as a limited parmership.13 The limited partnership issues limited partner interests to capital investors and the general partnership interest to an affiliate of the management team (the GP).1° The management team operates through a management company which typically does not own any interest in the partnership, but does enter into an agreement with the partnership to provide management services in exchange for a fee (often two percent of the committed capital annually).15 This fee paid to the management company is ordinary fee income and is generally used to pay administrative salaries, overhead, and other costs of operating the fund.th The GP is an affiliate of the management company and invests some amount of capital in the partnership, typically one percent of the total committed capital, and also receives the right to share in a percentage, typically twenty percent, of the profits of the fund, if any.17 This interest, usually referred to as the "carried interest," represents a right to share in future profits:8 If the partnership were liquidated before making any investments, the carried interest would only be entitled to the initial invested capital as a distribution of assets and would receive nothing with respect to the profits interest.19 The carried interest of a private equity fund is structured so as to share in the total profits over the lifetime of the fund (limited to a fixed period, e.g., ten years).2° The fund will typically make multiple investments in portfolio companies over the life of the fund, and will monetize a number of them well before the end of the life of the fund.2' The income from these investments is divided among the partners of the fund as if it represented the total income from the fund.22 Thus, upon the sale of the first portfolio company, a GP may be entitled to twenty percent of the gain even if the fund may lose money on future investments. As a result, certain private JCT CARRIED INTEREST REPORT. supra note I. at 24 Fleischer. supra note 1. at 8. 14 Fleischer. supra note I. at 8. The GP tends to be a partnership for tax purposes. ultimately owned by taxable individuals eligible for preferential capital gains rates. For purposes of simplicity, this Article will refer collectively to the "OF' to encompass both the entity and its owners. 12 Id. 16 See Postlewaite. supra note I (manuscript at 33). 12 Fleischer. supra note I. at 8. la Id. 19 See Postlewaite. supra note I (manuscript at 35). w See Mark P. Gergen. A Pragmatic Case for Taring an Equity Fund Manager's Profit Share as Compensation. 87 TAXES 139. 142 (2009). 11 See Paul H. Asofsky. U.S. Private Equity Funds: Common Tax Issuesfor Investors and Other Participants. 630 PLUTax 1275. 1295-96 (2008) (referring to this as the "realized investment" model). 22 Id. 718 EFTA01119572 NOT ALL CARRIES. INTERESTS ARE CREATED EQUAL 6/10/2009 6:53:25 PM Not All Carried Interests Are Created Equal 29:713(2009) equity funds provide for a "clawback"—or the obligation of the GP to repay the fund for any excess carried interest it withdrew from the fund in earlier years." In turn, the limited partners (LPs) are often subject to a "lockup"— requiring them to stay invested in the fund for the life of the fund.24 For this reason, most private equity fund GPs do not take distributions of carried interest on a current basis. Rather, cash must first be distributed to the LPs such that their capital is returned (and at times, a preferred return on capital is paid as well), and only then may the GPs receive distributions.25 The one general exception is that the GP is permitted to withdraw cash advances against the carried interest from the fund to pay their personal taxes attributable to the carried interest.26 These withdrawals are subject to the clawback, which makes the clawback meaningful even though the GP generally does not withdraw cash with respect to the carried interest before the LPs are paid." Carried interest in a private equity fund is economically similar to the LPs of the fund lending money to the GP on a nonrecourse basis to acquire a capital interest in the partnership.28 That is, if the fund makes money on its portfolio investments, the GP shares in the profits only after "repaying" the loan to the LPs; in other words, the GP only receives money if the portfolio companies appreciate in excess of the LPs' initial cost (plus a preferred return on capital in some cases). If the portfolio investments decline in value, the GP does not receive any distribution on the carried interest but at the same time does not owe anything to the LPs. For example, assume a simplified private equity fund with one LP and one GP. The GP contributes one million dollars to the fund and the LP contributes ninety nine million dollars to the fund. The fund then acquires all of the stock of two different corporations as separate investments, each for fifty million dollars. The fund agreement provides that all proceeds will first be paid to the LP until it receives its ninety nine million dollars, and then paid to the GP until it receives its one million dollars, and then divided eighty percent to the LP and twenty percent to the GP. In year three, the first investment increases in value from fifty million to one hundred and fifty million dollars and the fund sells it for cash. First, the LP receives ninety nine million dollars. then the GP receives one million dollars, after JCT CARRIED IN I Ele-S I REPOR I . supra note 1, at 2; Weisbach. supra note I. at 723. 24 Needham & Brause. supra note 12. at A-7 ("After the initial capital commitment, an investor in a private equity fund assumes a passive role during the remaining life of the fund. waiting until the fund calls capital or sells an investment."). Weisbach, supra note 1. at 722-23. 16 Abrams. supra note I. at I. 27 Id. Cunningham & Engler. supra note 1. at 126-27; Fleischer. supra note I. at 40; Weisbach. supra note 1. at 734 ("The closest analogy to a profits interest is a taxpayer who takes out a nonrecourse 719 EFTA01119573 NOT ALL CARRIES. INTERESTS ARE CREATED EQUAL 6/10/2009 6:530.5 PM Northwestern Journal of International Law & Business 29:713 (2009) which the GP receives ten million dollars and the LP receives forty million dollars of the remaining fifty million dollars. In year four, the second investment becomes worthless and the fund sells it for nothing. Over the life of the fund, the total profits were fifty million dollars—twenty percent of which is ten million dollars. Even after paying the carried interest, the LP received a return of slightly higher than forty percent on the initial capital investment, which is significantly better than most investment-based returns. The GP, on the other hand, earned a staggering return of one thousand percent on its invested capital. Hedge funds operate in a fundamentally different manner. Since they tend to trade regularly and invest in numerous different investments, the committed capital is rarely locked-up in any significant manner (beyond perhaps an initial start-up period).29 Rather, investors in a hedge fund typically have had the right to withdraw their investment, plus their share of investment returns, at regular intervals (for example, quarterly).3° In turn, the hedge fund manager charges an "incentive fee" against the profits of the fund.31 This incentive fee is then paid (in one way or another) to the hedge fund manager at that time; the payment is complete and not subject to any clawback or other right to claim a repayment from the investors, even if the fund loses money in the future.32 Thus, investors in hedge funds own a much more liquid investment than a private equity LP interest but also are charged the equivalent of carried interest on an ongoing basis with no right to reclaim such amounts for future losses.33 Hedge funds are typically structured as multiple entities, some partnerships and some corporations; the capital is then pooled among these related entities and used to make the investments of the hedge fund. The 29 See Needham & Brause. supra note 12. at A-7; see generally Ordower. supra note II. at 366-67. J° In light of the recent financial crisis, however, some hedge funds have taken the extraordinary measure of limiting withdrawals or redemptions due to liquidity or financial constraints. See, e.g.. Zachary Kouwe. Hedge Fund Lets Investors Withdraw What Is Left. N.Y. Times. Feb. 9. 2009. at B8 ("Several large hedge funds, including Citadel Investment Group and Farallon Capital Management. have halted investor redemptions in certain funds after having huge losses last year."); Tom Petruno. Exits Barred at Some Funds: Hedge Managers' Limits on Withdrawals Amid Market Turbulence Could Hurt Investor Confidence. LA. TIMES. Aug. 2. 2007. at C-1; Louise Story, A Squeeze on Leading Fund Chiefs. N.Y. Times. Sept. 30. 2008. at CI ("On Tuesday. RAB Capital. a British fund manager reportedly froze redemptions on its fund for three years ...."); Louise Story. Hedge Funds Are Bracingfor Investors to Cash Out. N.Y. TIMES. Sept. 29. 2008. at CI. 3i Needham & Brause. supra note 12, at A-8. 32 Id. at A-9; Weisbach. supra note I. at 723 n.12. n Needham & Brause, supra note 12, at A-7 ("The investor in a hedge fund has more control over the sales process. It initiates the process by notifying the portfolio manager that it intends to withdraw from the fund."). 34 Hedge funds use multiple suuctures to accomplish this. such as "master feeder" and 720 EFTA01119574 NOT ALL CARRIES. INTERESTS ARE CREATED EQUAL 6/10/2009 6:53:25 PM Not All Carried Interests Are Created Equal 29:713(2009) manager of the hedge fund charges the incentive fee in one of two ways: ( 1) for the partnerships, the manager owns a profits interest similar to a carried interest and (2) for the corporations, the manager charges a fee for the investment services of the manager.35 These incentive fees are charged on a regular basis based on the value of the assets of the fund at the time of the calculation.36 Assume the same facts as above, except that the fund is a simplified version of a hedge fund rather than a private equity fund and the incentive fee is calculated on an annual basis. In year one, the hedge fund purchases ten different assets for ten million dollars each. By the end of year two, the assets as a whole have increased in value to two hundred million dollars. As a result, the GP charges an incentive fee of twenty million dollars, or twenty percent of the one hundred million dollar profit, which is paid to the GP at the end of the year. The next year, the assets decline in value to one hundred million dollars. Since there is no profit, the GP does not charge an incentive fee in year three, but also is not required to repay any of the twenty million dollar incentive fee it received in year two.37 III. TAXING CARRIED INTEREST: THE DEBATE Given the significant differences in business model, legal structure, and economic agreement between the GP and LPs, it makes sense that the analysis for hedge funds and private equity funds might differ when "hub and spoke" structures—regardless. the basic premise remains that multiple entities pool capital to make investments on behalf of the fund. See Needham & Brause. supra note 12. at A-3-4: Ordower. supra note II. at 361-64. Is See Needham & Brause. supra note 12. at A-8-9. 36 See Ordower. supra note II. at 347: Rarely do fund managers return any portion of incentive fees they have collected previously when assets decline in value following an incentive fee. Rather managers agree to claim subsequent incentive fees only when the value of the investor's interest exceeds the incentive fee floor or "high water mark." The floor is the highest value of that investor's interest upon which the manager previously collected an incentive fee. This floor computational method prevents the manager from collecting multiple incentive fees on cyclical increases and decreases in value in volatile markets. The floor. however, does not preclude retention of fees attributable to aberrant market spikes since the value of an investor's account is the investor's share of the net asset value of the fund without regard to whether the fund has realized any gain by disposing of positions. D7 Under a provision sometimes included in hedge funds often known as the "high water mark." the manager would not be able to charge an incentive fee again until the assets appreciate in excess of two hundred million dollars. See Jerald David August & Lawrence Cohen. Hedge Funds—Structure, Regulation and Tax Implications. 815 PLIJTAx 131. 142 (2008). 721 EFTA01119575 NOT ALL CARRIES. INTERESTS ARE CREATED EQUAL 6/I0.2009 6:530.5 PM Northwestern Journal of International Law & Business 29:713 (2009) considering the tax treatment of carried interest, notwithstanding that both types of funds use a similar means to compensate GPs as an incentive to maximize returns. To examine these distinctions in more detail, this Section will summarize the current debate regarding the taxation of carried interest. Much has been written about the taxation of carried interest, and there is little need for a retelling of all the issues in detail, and thus this Section will only frame the existing debate. As discussed in Section II, carried interest in private equity funds is typically issued in the form of a profits interest in the limited partnership. The GP receives the profits interest as an affiliate of the management company, which provides the investment services for the fund. Thus, the sole reason the GP is issued the profits interest is in exchange for the services. In general, for tax purposes, when a service provider receives property in exchange for services, the value of the property is treated as salary, or ordinary income, on the date of issuance.38 The treatment of the receipt of a profits interest in a partnership has been more controversial, however, with the courts, sovernment, and commentators often reaching contradictory conclusions.]9 In part to resolve this confusion, in 1993 the Internal Revenue Service (IRS) formally announced that, under certain conditions, it would treat a profits interest as if it had no value at the time of issuance, with the result that there would be no income to the GP upon the grant of a carried interest.d0 The position of the IRS with respect to the issuance of profits interests in exchange for services is based on the theory that the value of a profits interest is equivalent to the amount of capital allocated to the interest in the "capital account" of the partnership, or the "liquidation value" of the interestd1 Ignoring the minimal contributed capital, since the GP would receive no distributions if the fund never generated any profits, and is not entitled to any capital of the partnership at the date of the grant, the profits interest is deemed to have no value at issuance. This is clearly a legal fiction; the carried interest must have some economic value to the GP since the GP accepted it in the first place and could earn substantial amounts in the future. The fiction is consistent with the general methodology used to 38 26 U.S.C. § 83 (2008). " Compare Diamond v. Comm., 56 T.C. 530 (1971), aJJ'd 492 F. 2d 286 (7th Cir. 1974) (ruling that a profits interest was taxable upon receipt) with Campbell v. Comm., 943 F. 2d. 815 (8th Cir. 1991) (reversing a Tax Court ruling that receipt of a profits interest was a taxable event). See also JCT CARRIED INTEREST REPORT. supra note 1. at 6: Weisbach. supra note I, at 727 n.22: Leo L. Schmolka, Commentary. Taring Partnership Interests Exchangedfor Services: Let Diamond/Campbell Quietly Die. 47 TAX. L. REV. 287 (1991). i0 See, e.g., Rev. Proc. 93-27, 1993-2 C.B. 343: see generally ARTHUR B. Wnsts, JOHN S. PENNELL & PHILIP F. POSTLEWAITE. PARTNERSHIP TAXATION I 4.06p] (6th ed. 2002). 4I See WILLIS. PENNELL & POSTLEWAITE. supra note 40.7 10.05. 722 EFTA01119576 NOT ALL CARRIES. INTERESTS ARE CREATED EQUAL 61102009 6:53:25 PM Not All CarriedInterests Are Created Equal 29:713(2009) account for partnership income for income tax purposes, however.02 Although the rules work such that by the end of the life of a partnership the items of taxable income and economic income should match, due to this fiction they do not match at the time of issuance. The fund is treated like a partnership for tax purposes, meaning the income, gains, losses, deductions, and credits of the fund "flow through" to the partners of the fund regardless whether any cash is distributed." The partners then include such items in their personal tax returns. The fund utilizes an accounting mechanism of "capital accounts" to keep track of which partner is entitled to what assets as income, gains, losses, and credits are generated at the fund level." The fund allocates these tax items among the partners and the tax law generally respects the manner in which the partnership does so, as long as the allocations have "substantial economic effecr—effectively, so long as the allocation of the tax items also adjust capital accounts:" In this manner, the tax laws are structured so that the allocation of taxable items corresponds to the economic realities of how the partners are actually sharing profits and losses. For tax purposes, as a partner of the fund the GP is allocated a share of profits from the sale of portfolio companies as they occur. These profits flow-through to the GP at the time of the sale, and the character of such income is determined at the partnership level." Since the profits interest is considered an interest in the partnership under this approach, the income attributable to the GP is considered to be a portion of the income of the partnership. For the most part in private equity funds, the income is primarily gain from the sale or exchange of stock in portfolio companies. Thus, assuming the gain from the sale is capital gain for tax purposes, it flows through to the GP as a partner in the partnership and is reported as capital gain by the GP. Since the members of the GP ultimately are individuals, they are generally eligible for preferential rates on capital gain:" The controversy that arose was not over the technical application of these rules, but rather that, through the application of these rules, managers of private equity funds were effectively being compensated for their services while receiving income in the form of capital gain for tax 42 The partnership tax accounting mechanism is intended to reflect the partner's current share of assets of the partnership. This simplifying methodology is assumed solely for tax purposes to reflect the we economic relationship of the parties. Id. a See generally id. ?I 10.01-05. " 26 U.S.C. 1§ 701-704 (2008). See generally WIL1JS. PENNEIA. & POSTLEWAITE. supra note 40,1 10.04. 46 26 U.S.C. 1 702(b) (2008). For a more detailed discussion. see infra Section IV. 47 26 U.S.C. 1 1(h) (2008). For a more detailed discussion, see infra Section IV. 723 EFTA01119577 NOT ALL CARRIES. INTERESTS ARE CREATED EQUAL 6110.2009 6:530.5 PM Northwestern Journal of International Law & Business 29:713 (2009) purposes.d8 This can be seen by returning to the example in Section II above, in which the LP received a return of almost forty percent on its invested capital while the GP received a return of one thousand percent on its invested capital. Why did the GP earn such a disproportionately higher return on its capital than the LP? It would appear that the only way to explain this disproportionate return for the GP would be that the return was not really on invested capital but rather compensation to the GP for finding and managing the investments of the fund. Since other money managers, such as those at mutual funds and investment banks, do not receive compensation as capital gain, but rather receive fees or salaries treated as ordinary income, proponents of changing the taxation of carried interest claim that this disparate treatment violates the norm of horizontal equity, which provides that similarly situated taxpayers should bear similar tax burdens.d9 Proponents of maintaining the current law treatment of carried interest counter that horizontal equity may not be a useful tool in analyzing blended scenarios such as carried interest, because they can be considered "similar" to two different and opposite treatments.50 In the words of Professor Weisbach: It is as if we had to choose a color for three squares arranged in a line. The square on the right is red and the square the left is blue. If we must choose red or blue for the middle square, we cannot pick a color by noting only that the square to the right is red, ignoring the blue square on the left. Horizontal equity arguments fail entirely in this context.st Under this analysis, the taxation of carried interest is purely an exercise in line-drawing across a spectrum, since the law creates two inconsistent poles at the far ends (capital gain on one and ordinary income on the other) while a third choice (carried interest) falls in the middle. Viewed from this perspective, proponents of the current law treatment claim less distortions would arise from treating GPs in private equity funds more like "sweat equity"—or the gain in the value of a business derived n Fleischer. supra note 1. at II I& 44-46. 49 See. e.g.. Henry Ordower. Taxing Service Partners So Achieve Horizontal Equity. 46 TAX LAW. 19. 41 (1992)1 see also Fleischer. supra note I. at 44-47. The usefulness of horizontal equity as an independent norm in the tax laws has been challenged. however. See. e.g.. Weisbach. supra note I. at 740. This does not mean that GPs always earn such staggering returns, or that private equity funds never lose money. but rather that since such returns are possible it is difficult to argue that the returns on carried interest are solely in the nature of a return on invested capital. and thus horizontal equity comes into play. f0 Weisbach, supra note I. at 718. " Id. 724 EFTA01119578 NOT ALL CARRIES. INTERESTS ARE CREATED EQUAL 6/102009 6:53:25 PM Not All Carried Interests Are Created Equal 29:713 (2009) from the work of its owners—than compensation for services.52 In addition to the claim that the taxation of carried interest as capital gain violates the norm of horizontal equity, proponents of reform also contend that such taxation violates the underlying policies supporting the distinction between ordinary income and capital gains.31 In particular, as discussed in more detail in Section IV infra, capital gains are treated differently than ordinary income due to two policy concerns: (I) bunching and (2) lock-in. In general, bunching refers to the phenomenon that gains from sale of assets accrue over time but are realized all in one year, while lock-in refers to the concept that investors have an incentive not to sell an asset solely to avoid tax.m The primary concern with bunching and lock-in is that, as more gain accrues over time, the more tax will be paid upon a sale of the asset and thus the worse the problems become; to address bunching and lock-in, Congress adopted preferential rates for the taxation of capital gains.ss A fundamental aspect of the bunching and lock-in phenomena is that they require an upfront investment in an asset and gain derived from that investment; in other words, the gain subject to bunching and lock-in is the return on the initial capital investment. In the case of carried interest in a private equity fund, however, there is nominally no upfront capital investment by the GP. Rather, the GP is effectively earning a return generated on the capital contributed to the fund by the LPs. Thus, one 63 Id. at 719 ("From a line drawing perspective the choice is clear we should not change the treatment of carried interests in private equity partnerships."). 51 See, e.g.. Fleischer. supra note I. at 43. m See Burnet v. Hamel, 287 U.S. 103, 106 (1932). This is not to say that bunching and lock-in are the only justifications for the capital gains preferences. or that they are sufficient to normatively justify a capital gains preference. rather only that they are the beginning of any discussion as to the purpose of the capital gain preference under current law. See JOINT COMM. ON TAXATION. TAX TREATMENT OF CAPITAL GAINS AND LOSSES. 30-36 (1997) [hereinafter JCT CAPITAL GAIN REPORT]. 55 Of particular concern was that a large portion of such gain could be comprised solely of inflationary returns, and thus not represent any increase in the ability to consume. See Noel B. Cunningham & Deborah H. Schenk. The Case for a Capital Gains Preference. 48 TAX L. REV. 319. 337 (1993). It is arguable whether the capital gains preference is the optimal way to fulfill this policy, or whether it does so at all. See, e.g., John W. Lee. Critique of Current Congressional Capital Gains Contentions. 15 VA. TAX REV. 1 (1995): Michael J. Waggoner. Eliminating the Capital Gains Preference Section I: The Problems of Inflation, Bunching. and Lock-In. 48 U. COLO. L. Rev. 313 (1977). For example, indexing basis for inflation could directly address the inflation issue. See JCT CAPITAL GAIN REPORT. supra note 54. at 36-39. It is clear, however, that these are the stated policies for the capital gain preference and that the rules crafted with respect to it have been justified in this manner. regardless of their efficacy. See, e.g., John W. Lee. The Capital Gains -Sieve" and the "Farce" of Progressivity 1921-1986, 1 HASTINGS Bus. L.J. 1 (2005). Thus, solely for purposes of analyzing the issue in the context of the carried interest debate, it is sufficient to focus on these policies. 725 EFTA01119579 NOT ALL CARRIES. INTERESTS ARE CREATED EQUAL 6/10.2009 6:5335 PM Northwestern Journal of International Law & Business 29:713 (2009) argument has been that the income attributable to the profits interest is really income from services and not capital, and the GP should not be entitled to capital gain treatment because there are no bunching or lock-in concems.s6 Critics of this argument counter that current law permits an identical result through borrowing funds to make an investment, and thus this result does not violate any deep norm regarding the capital gains preference." In addition to the normative debates over reform of the taxation of carried interest, critics have noted that there are multiple problems with the implementation of any reform proposal as well.ss One particularly vexing problem is that any reform targeted solely or primarily at private equity funds would require some change to the underlying fundamental treatment of the allocation of income in a partnership for tax purposesS9 For example, one way to address carried interest would be through an analogy to other property issued to service providers (i.e., ordinary income at the time of grant equal to the fair market value of the property and capital gain for any future appreciation)." Under current law, the capital account of the GP at the time of issuance is zero, and thus the partnership tax accounting rules assume it is worth zero. As a result, if the "forced valuation" proposal were adopted, the GP would be taxed on having received compensation, but the partnership tax laws would assume that the GP would not be entitled to any of the assets of the partnership, resulting in a mismatch that could lead to timing, character, and amount of income distortions.6t One way to remedy this would be for the GP to receive a capital account equal to the amount of the income inclusion. Doing so would result in one of two anomalies—either the capital accounts would no longer reflect the value of the assets of the partnership, or the GP would have to "take" capital account away from the LPs. In either case, absent exceedingly complex 56 See Fleischer. supra note I. at 44-46. " Weisbach, supra note I. at 741-44. sa Eg.. Postlewaite. supra note I: Weisbach, supra note 1: Abrams. supra note I. 59 Abrams. supra note 1. at 9-11: Postlewaite. supra note 1 (manuscript at 5) ("Critics examine only part of the evidence in compiling their case against the status quo. Furthermore. they fail to integrate the full fabric of Subchapter K and the taxation of partners and partnerships into their assessment of the area."). w See Fleischer, supra note L at 52 (referring to this as the "forced valuation" method). 61 Abrams. supra note I. at 9-11. A similar proposal to treat carried interest similar to ISOs suffers from this same malady, since any attempt to impose a valuation on the profits interest upon issuance requires facing the partnership accounting issue as well. See Adam Lawton. Note, Taxing Private Equity• Carded Interest Using an Incentive Stock Option Analogy.. 121 Hay. L. REV. 846 (2008). An additional proposal. to treat "human capital" as contributed capital so as to make the capital accounts work. may address the capital account issue but continues to confront the line-drawing issue for blended returns. See Sarah Pendergraft. Note, From Human Capital to Capital Gains: The Puzzle ofProfits Interests. 27 VA. TAx REV. 709 (2008). 726