[edited to correct error in statement May 24, 2010]
The NY Times' Andrew Ross Sorkin has an article on the likely passage of a carried interest bill. Bobbing as Taxman Weaves, NY Times, May 18, 2010, at B1. REcall that hedge fund managers, equity fund managers, venture capital managers, real estate partnership managers all currently claim that their payments from the partnership for managing the partnership that are in the form of a "carried interest" paid on their partnership profits interest--a percentage of the partnership income or gains allocated to them annually--should benefit from the same capital gains treatment that is available to capital partners when a partnership asset is sold and generates capital gains passed through to the capital partners. Many tax experts believe that these profits should be taxed as ordinary income just like the wages of everyone who gets a regular paycheck.
The current tax provisions governing this are unclear. There is some obscure case law, some recent administrative pronouncements, and a lot of bravado on the part of tax advisers who regularly advise hedge and private equity firms. But it is likely that Congress will pass some sort of provision this session that will explicitly treat this carried interest as the compensation income that it is and require it to be taxed at ordinary rates.
Naturally, these wealthy managers and their tax advisers are already devising schemes to get around the results of the expected new tax law. Sorkin's article outlines a few under consideration:
1. Sell the carried interest immediately, use the cash to invest in the deal, so any increase will be capital gain
If a profits interest is sold, generally it is being sold for the expected future income. If that is significant so that the interest has a value, then that should mean that the partners would have to take into account a considerable portion of the future value to be received as ordinary income at that point--i.e., the sale of a profits interest should itself be treated as ordinary income.
2. Have the limited investors lend money to the managers, rather than transfer a carried interest, and then have the managers use that money to purchase a capital interest.
This has the potential for recharacterization under substance over form principles (especially if the partnership pays back the managers loan with the "investment" dollars) since the carried interest is still being received as payment for services. Sorkin says this gambit "appears to have already been outlawed by language in the latest bill" (I need to doublecheck that).
3. Move the partnership offshore
The managers would claim that services are rendered offshore and hence not taxable in the US (services income is sourced according to where the services are rendered). This favors the already obscenely paid managers over investors, since investors would lose the legal protections of the US markets. I've often wondered why investors would allow the overpayment of managers, since many of these funds don't provide the kinds of returns that are bandied about (quite a few end up with noncompetitive returns once the fees, carried interest, and other expenses are figured in). So who knows whether investors would demand that the funds serve them rather than the overpaid managers... Congress could deal with this by exacting a "expatriation tax from any business or fund that moves offshore, to the tune of full taxation of any unrealized gains, but it has been very reluctant to do, perhaps due to the whining about "competitiveness".
4. Dismantle partnerships and create individual companies for each deal, with managers given "founders shares" of common stock.
Again, this move favors managers' interests in not having to pay the ordinary tax on their wages that others have to pay at the expense of investors' interests, so it hardly seems like investors should grab onto this solution. It adds transaction costs as well, which would also eat into investors' returns. And it requires more hands on attention (one-off decisions on every opportunity) from the limited investors who are generally attracted to the hands off possibilities of funds. Plus the single deal situation would likely result in premium and discount pricing for unlucky or privileged investors (respectively), causing more consternation with the structure designed to provide low taxes for managers. Again, Congress might question whether the provision of "founders" shares for services to be provided isn't just payment of compensation in kind that should be taxed accordingly.
5. Lobby for an exclusion
This is the path being taken by the real estate and venture capital industries. Venture capitalists argue that they do an important service in helping start up companies, and removing the tax giveaway would just discourage this service. Bunko--managers aren't going to stop making millions just because they have to pay more in taxes now than before. Venture capital will continue much the same as always. It's just that managers will be paying something a little closer to their fair share of the tax burden that they have avoided for all these years. Real estate venturers argue that taxing them would hurt the real estate industry at a time when it is suffering because of the financial crisis. Similarly bunko. Taxing managers won't hurt the industry. To believe that you have to buy hook line and sinker the Chicago School ideas about substitution of leisure for work when work becomes less rewarding. (Like most pieces of freshwater economic theory, this one ignores the polycentric nature of human decisions.) And then you have to believe that the few managers that slow down or retire because they have to pay a little bit more of their riches in taxes will "discourage" the entire industry, as though there aren't some job-hungry financial nerds out there just waiting to take their places, taxed at ordinary income or not.
Congress should stick to its guns on this one, and more so. Ignore the lobbyists. Disregard the whines of people who've been enjoying an undeserved tax break for decades. And add some anti-abuse language to the bill to deal with the various ideas that have been suggested to "structure around" the tax law.