ataxingmatter

Circular 230 Revisions Discussed at ABA Tax Section Today

Not quite a decade after the much-hated "covered opinion" rules, the Treasury and Service today announced proposed amendments to Circular 230 that wipe the slate clean.  See REG-138367-06.  The amendments include a few other changes that will assuage some worries about the role of OPR in discipline of attorneys.

The government panel at the ABA Tax Section Standards Committee introduced the changes.  Karen Hawkins, OPR Director, was "excited about the changes".  Section 10.1 clarifies the authority of OPR as the office with exclusive responsibility for discipline and sanctions of attorneys.  This issue had been a concern after the most recent amendments, which took out all references of OPR to accommodate the introduction of the new Return Preparer Office. 

Changes to section 10.31 make it clear that attorneys may not use "self-help" to acquire repayments from client's tax refunds.  Whether a refund is through a paper check or some electronic means, attorneys must turn it over to the client and may not deposit to their accounts, including trust accounts.  Hawkins noted that this was a "broader rewrite than some anticipated".  The result is consistent with the section 6695 regulations, and applies to all tax practitioners.

The big change was section 10.35.  The strict rules for written opinions and disclaimers are removed, with core principles of tough due diligence requirements incorporated in section 10.37, now the single provision covering written opinions.  The extensive disclaimer requirements are gone.   Why the change?  Several reasons.  While opinion practice seems to have improved (for the nonce), the government concluded that the strict rules in 10.37 were not an effective tool in squelching over-aggressive tax advice.  It had been expected the disclaimers would get the attention of clients, but instead they were generally not seen as a problem by sophisticated clients and created a confusing trap for unsophisticated ones.  Tax practitioners complained mightily about the difficulty of complying with the rules from the outset, saying the rules were too costly and too burdensome.  It's likely that oral opinions substituted for written advice as a way of avoiding having to comply. 

New 10.35 is a quite short provision that requires attorneys to have the requisite skill, knowledge and competence for the role they are undertaking.  Astonishingly, though the Model Rules have long included such a requirement, Circular 230 governing practice before the IRS had not.  This is what might be called a "no-brainer" addition.

Section 10.36 places more responsibility on the person in a firm with principal authority for overseeing Circular 230 practice.  That person must take reasonable steps to be sure that everyone understands their Circular 230 obligations.  If s/he fails, s/he will be held personally liable.  If s/he takes steps but those s/he oversees still violate the rules and s/he does not take additional steps to stop the violations, personal liability is again possible.  As Hawkins said at the meeting, this is essentially a "respondeat superior" type of obligation.   An audience member asked about the application of this rule when there are independent contractors.  Hawkins noted that there is an interrelationship here between section 10.22, which requires due diligence and allows a practitioner to rely on another, and 10.36 which requires appropriate oversight of employees or the work cannot be relied on.  Either way, she noted, poor due diligence will result in being unable to rely on the work, under either 10.22 or 10.36.  (And Section 10.37 would be relevant if the independent contractor is preparing an opinion on which the practitioner expects to rely.)

 Section 10.37 is, as noted above, now the provision that governs all written tax advice.  It is, Hawkins said, a "sensible form of regulation that everyone can understand and follow, including both practitioners and clients."  There are some significant changes beyond the elimination of the covered opinion rules.  For example, the original section 10.35 did not permit practitioners to consider settlement possibilities in giving written advice: under the proposed regulation, it is permissible to consider the hazards of litigation, but not the potential outcome of audits.  Rich Goldstein pointed out that "the regulations retain a 'heightened scrutiny' for marketed opinions, so they are not a shift back to the pre-2004 status but rather a decision to provide a rule that was easier to work with, easier to enforce and one that had the potential to be effective."  Questioners asked what heightened scrutiny is intended to mean in this context.  Hawkins reminded everyone that "the basic standard is reasonableness."  Goldstein explained that "if the opinion is marketed, it will be reviewed closely to ensure that it complies with the requirements, because the effect on tax administration is greater."   In other words, there is not a different standard or level of confidence required by the practitioner, but a difference in how it will be reviewed.

Section 10.82 provides for expedited suspension in situations where there has already been a fitness adjudication by another body, such as a tax crime conviction or the loss of a state bar license.  These amendments add the possibility for expedited suspensions when practitioners have demonstrated willful disreputable conduct by failing to comply with tax filing obligations--e.g., failing to file for 4 of the last 5 years.  Hawkins noted that with many new practitioners, it is reasonable to expect that there will be some compliance problems, and it would be a drain to have to take all of those cases before an administrative law judge when the result is clear.  Although there was a similar effort to create additional expedited process a decade ago, Hawkins suggested that this revision was "better, more thoughtful, and more confined."  But having opposed the original attempt to permit expedited process in these types of situations, she noted that she "would particularly invite the Committee to provide feedback on this issue.  She reminded that in an expedited suspension, OPR initates the process with what is now called an "order to show cause" to the practitioner, who can talk to OPR and perhaps end the process.  If not, the suspension takes place and then full due process protections apply.

The notice also withdraws the proposed regulations for state and local bonds, proposed in 2004.

There is a comment period for 60 days, which will end November 15, and a hearing will be held December 7.  Hawkins noted that it is important to let the government know if they have missed something since otherwise "in two-three years we will be back in the same place again with a variant of 10.35, if these rules are not effective."

Romney's Foreign Policy Creds--nonexistent

Warning:  this is not a tax post.  As I sometimes do, I comment here on current affairs that will indirectly impinge on tax law and policies but are not directly related to my ordinary topic.

The assassination of our representative in Libya and several other officials was a tragedy that demonstrates the irrationality of religious fervor on both sides.  Apparently some right- wing Christian fundamentalists created a hate-mongering film about the Islamic religion.  Just as Christians resent attacks on their religion, Muslims resent attacks on theirs.  The film, when it became widely noticed, stirred anger and resentment against the US for harboring groups that spew such hate.  Such anger is understandable, even though we cannot condone it or the violence that grows out of it.  Our embassy in Libya rightly condemned the hatemongering, noting that America is a country that tries to practice tolerance of many religious views without condoning violence towards any.  That was the appropriate response, because it acknowledged the fundamental free-speech right recognized in the United States, which allows people to say stupid and even hateful things about other people and other people's religion, but it nonetheless condemned those stupid and hateful things as stupid and hateful and damaging to the respect that is necessary to a peaceful world.

Regretably, the response in parts of the Arab world to the hatemongering film escalated to violence, and American representatives suffered the brunt of those attacks.  We lost public servants who have made a substantial contribution to building better societies.

But Romney's response only adds to the problem.  With his hastily released statement condemning the President for "apologizing" to terrorists (a lie), he turned a national tragedy into a political moment, making a statement that wrongly described the embassy's statement as a response to the violence The embassy's statement of tolerance is the epitome of what America is all about.  Romney hoped to jumpstart his (nonexistent) foreign policy credentials by criticising his opponent, claiming that the President had issued an apology and implying that Americans should never apologize.

Romney's response demonstrates his incapacity for leadership.  His only thought was how to advance his own personal agenda, not how to help the nation.  He didn't mind mixing fact and fantasy in his claims (the embassy statement was before, not after, the violence, and was a reasonable statement of America's views on freedom of speech and religion).  Obama didn't apologize.  Further, as other writers have noted, there is nothing inately wrong with apologies when they are in order--it would be quite reasonable for an American to say to a Muslim from Libya that they apologize for the ignorance and hatefulness of the right-wing extremists that are fomenting anti-Islamic sentiment in the United States right now. 

Romney revealed himself, yet again, as an opportunist who speaks before he gets his facts straight.  (or, as Obama put it, shoots before taking aim).  He also revealed how ill-equipped he is to deal with the delicate situation in the Middle East, where the outcome of the clash between the desire for democratic rights and the desire for fundamentalist religious hegemony remains undetermined.  Romney is clearly cut from the same cloth as the militarist George W. Bush, who thought he could huff and puff and show the military stuff of the United States and accomplish war with no bloodshed, victory with no taste of agony.  Bush was wrong, and so is Romney.

Romney also showed that the military-industrial complex is at work again, building a drumbeat for more money, more appropriations, more military goodies, more war--no matter the cost to domestic livelihoods.  We do not need to go to war against Iran, but it is seems that the religio-military-plutocratic complex is trying to make such a war inevitable and that Romney is a willing pawn in that endeavor.

The Iraq and Afghanistan wars are a significant cause of our incredible debt burden, not to mention of the maiming of thousands of young Americans.  We will ultimately have to increase taxes--such as by letting the ill-advised Bush tax cuts expire-- to cover the long-term fallout of those wars.  If we were to take on another long-term and unwinnable war with Iran, the cost--in lives and in the blow to our economy--would be enormous.  Let us hope that foolish minds like Romney's don't force us into an untenable position.

Romney's Carried Interest and Capital Gains Rates Generally

As most everybody knows by now, Mitt Romney, the GOP nominee for president, refuses to release anything other than the 2010 tax return we've seen (and sometime soon, it is promised, the 2011 return).  Without more tax returns--and more complete return-related information--Romney is basically telling voters they have no right to know how he invests and earns his vast wealth. 

It just ain't so. 

First, voters have a valid interest in knowning how Romney invests his great wealth.  Passive investments, "hobby" investments, treatment of his later years at Bain Capital, treatment of his "retirement" income from Bain--all of those are of valid interest.  Then there is the question whether Romney has consistently held a lot of his wealth offshore during many years? And did he report his offshore accounts and income as he was supposed to, back in the days before Birkenfeld opened the crack in Swiss banking secrecy, or did he end up participating in the IRS amnesty program in order to avoid criminal prosecution for his failure to file FBARs?  We surely have a valid interest in those questions and more about the way Romney's wealth is held.

Second, voters have a valid interest in knowing (and understanding) how Romney acquired his great wealth.  Yes, he was born into a well-to-do household and that gave him an incredible leg up on every American who is not born into the lap of wealth, even before he received his inheritance  from his father's estate(which he purportedly contributed to charity).  But he claims to have a wealth of business expertise that will allow him to be a good president, and that rests on his role at Bain Capital.  But there he is caught up in the rarified world of equity fund managers--people who, through an interpretation of the Code, not through a specific provision providing for it, claim that their "carried interest" compensation income can be treated as capital gains rather than as ordinary income.  As a result, they pay a very low rate of tax.  And their "job" is to buy  out firms, almost always by leveraging them up so they can use other people's money to make the acquisition, and not infrequently by running them into bankruptcy, resulting in Mitt Romney getting to fire people (he said he enjoys it).

Bruce Bartlett, a veteran GOP economic adviser, even agrees with the majority of tax experts who have come out against the "carried interest" loophole and argues that it "can and should be addressed by treating carried interest as ordinary income."  See Economix- Bruce Bartlett, Mitt Romney, Carried Interest and Capital Gains, New York Times (Sept. 11, 2012).

Bartlett is correct that we can and should address the ridiculous carried interest loophole--it is well past the time that Congress should have acted to quit favoring the richest folk amongst us with preferential treatment of the compensation they receive for their asset-management activities.

But Bartlett is wrong about whether the effort to fix capital gains problems should stop there.  He argues against eliminating the capital gains preference with three well-hashed and relatively weak arguments.  Let me give you his arguments, and my responses, here.

1. First, he says, even if you got rid of the preferential rate, you wouldn't have completely eliminated the preference for capital gains in the Code, since gains aren't recognized until they are "realized"--meaning that the taxpayer has the ability to choose to dispose of a capital asset at the timing that suits him.  Gains can be deferred.  Losses can be accelerated.  (And they still avoid the payroll taxes that apply to wage income). 

The point is true but nonetheless not an argument against eliminating the preferential rate.  Congress is not likely to require mark-to-market rules, but it could easily write rules that make  monetization-without-taxation schemes  unworkable.  (One monetization scheme that has been often employed by wealthy taxpayer is to use shares as collateral for a loan, enjoy the money during life, and let the beneficiaires inherit the shares at stepped up basis and then sell them to pay off the loan--no cost in life; no cost to the beneficiary either.)  Another thing Congress could do to help prevent the "cherry-picking" of loss recognition-without-gain-recognition is to repeal the identification provision that allows taxpayers to pick out which of a bunch of identical shares (except for basis) they are selling.  Require all sales to be taken from all groups of shares.

The fact that eliminating the preferential rate for capital gains doesn't eliminate all the tax advantages that the wealthy will be able to enjoy from holding the vast majority of the financial assets doesn't mean that we should at least eliminate that significant advantage!

2. Second, he brings up the old saw about inflation and the fact that in times of significant inflation, the gain calculated as the different between current value and original cost basis will represent in part a "phantom" inflationary gain.  Indexing for inflation would be an administrative nightmare (that would invite wealthy taxpayer manipulation of the data, just as already happens with inflated bases).

The answer here is really "so what."  If we concede that taxpayers will still benefit--especially compared to ordinary income earners on whom taxes are withheld as the income is earned throughout the year--from having capital gains assets for which they can control the timing of taxation through the realization requirement, we should be quite willing to have a "rough justice" tradeoff the other way with whatever inflationary gains (or losses) may be represented.  This is especially true when one considers that the financial assets held mostly by the wealthy also give enormous other economic benefits during the time they are held--prestige, influence, and power are not to be ignored.   Further, the tax-free consumption power attained through monetization with loans (in circumstances in which it wouldn't be treated as a constructive sale, and depending on whether Congress would act to make monetization with no taxation impossible through elimination of the step up in basis on monetized assets) is another significant advantage.

3. The third reason given by Bartlett for not eliminating the capital gains preference is that it will be hard--people who get most of the capital gains preference are people of great wealth who "exercise influence in our political system far out of proportion to their numbers." 

This is a practical reality, but it is not a reason for deciding to retain the preference.  It is, rather, a reason for Republican and Democratic economists to speak up courageously and call for the repeal of the preference from the Code.  It is a reason for all of us to take the actions and policies of politicians favoring wealthy owners of capital into account in our votes.  It is a reason to think twice about electing a ticket (Romney-Ryan) in which both parties grew up in the upper middle class, have always had plenty of money, and don't have much understanding of what it is like to be down and out in America today.  It is a reason to find progressives who understand the problem of a tax code that preferences the wealthy plutocrats and corporate owners.

Whistleblower gets millions: good for compliance improvement (and makes us ask again--did Romney get amnesty?)

[Edited 9/13 to add link to Kenneth Thomas]

Bradley Birkenfeld, the UBS whistleblower who helped jumpstart the IRS's enforcement of foreign bank account reporting and helped catch criminal tax evaders, ended up serving a relatively short prison term (for failure to be entirely forthcoming, in the case of one of UBS's private banking customers) but also go a significant $104 million whistleblower award.  See David Kocieniewski, Whistle-Blower awarded $104 Million by I.R.S., New York Times (Sept. 11, 2012);  Whistleblower Brad Birkenfeld Rewarded Record $104M for Exposing How UBS Helped Rich Evade Taxes, DemocracyNow.org (video available); Exhaustive Study Finds Global Elite Hiding Up to $32 Trillion in Offshore Accounts, DemocracyNow.org (July 12, 2012) (video or transcript available); Birkenfeld's bonanza, The Economist (Sept. 11, 2012).

As Birkenfeld's attorney put it:

“Today is a great day for all the honest Americans out there who work their job and pay their taxes. Today is a great day for tax fairness. Today is a terrible day for big-time tax cheats.”  Birkenfeld's bonanza, The Economist (Sept. 11, 2012).

The very public and very large whistleblower award should do two things:

1) encourage other insiders who are aware of egregious company or individual tax-evading behavior to blow the whistle and

2) discourage other insiders and companies from egregious company or individual tax evading behavior.

There have always been anonymous brown-envelope tips to the IRS from those who know what is going on but don't want to participate in it and don't want their competitors to gain a competitive advantage because they do.  But whistleblowers generally have access to inside information that can break the dam on enforcement.  That certainly was the case with Birkenfeld, whose information-- about smuggling diamonds for UBS's private banking clients and other means taken to help such clients avoid reporting their assets to the US government--was instrumental in increasing awareness about tax crimes and increasing the fear of God (or rather, the fear of the "revenuer") in sophisticated, wealthy taxpayers who had been able to hide some of their assets and wealth relatively easily before.

By the way--we still do not know whether GOP presidential candidate Mitt Romney participated in the amnesty program that was introduced in the wake of the UBS exposure of banking secrecy's connection to tax evasion by wealthy Americans.  As most Americans know by now, Romney refuses to release his tax returns for the relevant years when he might have participated in the amnesty program to avoid criminal prosecution.  See, e.g., Kenneth Thomas, UBS Whistleblower's Award Reminds Us Romney Banked at UBS.  Until Romney does release his returns back to 2003 o4 so, there will continue to be questions regarding his taxes, as the wealthiest nominee ever with offshore holdings galore and his sole business experience being a hedge fund with numerous offshore entities and blocker corporations.  Specifically, Americans will wonder how his self-proclaimed patriotism and love of nation plays out in his ordinary decisions.  His hedge fund, Bain Capital, has also made the news as a participant in a claimed conspiracy of hedge funds to deflate the prices they pay for companies they acquire.  See Lichtblau & Lattman, Equity Firms Like Bain Are Depicted as Colluding, New York Times (Sept. 11, 2012).   Both tax evasion and price-rigging are criminal activities, so it behooves Romney to release his returns and ancillary information so Americans can assess how he practices what he preaches in terms of love of country and rule of law.  Did he report his foreign assets as required all along?  Did he invest abroad (so that any purported "job creation" activity didn't benefit us)?  Was he still influential in Bain during the period that it began, or carried on, price-fixing agreements with other powerful hedge funds?  Americans deserve to know.

Will this lead to better compliance in the future?  One suspects that there will always be those who enjoy the game of avoiding taxes so much that they will be willing to pay to play the tax evasion games even on the harder-to-manipulate playing field created by the crackdown on banking secrecy and offshoring of funds.  But hopefully they will be fewer, and less successful! 

Romer's deficit reduction suggestions worth a read

Christina Romer's recent piece in the New York Times is worth reading.  See C.D. Romer, Cutting the Deficit, with Compassion, New York Times at BU5 (Sept. 9, 2012).

Now, I generally have found Romer too willing to advocate austerity economics and too unwilling to support progressive tax policies.  But nonetheless, this piece hits some good notes.  For example, while arguing that reducing the deficit needs to be a priority, she acknowledges that it must be done "in a way that does as little harm as possible to people, jobs and economic opportunity."  Similarly, she recognizes that requires going slowly--" a comprehensive, aggressive deficit reduction plan [should be passed] as soon as possible, but the actual spending cuts and tax increases should be phased in as the economy recovers."  Why?  Because "[a] crude rule of thumb is that every $100 billion of deficit reduction will cost close to a million jobs in the near term."  A big price to pay that makes it reasonable to consider not only LONG-TERM deficit reduction plans but also SHORT-TERM job creation measures.

ASIDE:  And in case you wonder, tax cuts for the wealthiest amongst us, as advocated by the Romney-Ryan team--are NOT job creation measures.  The Romney-Ryan budget proposes to achieve revenue neutrality, huge tax cuts for the rich, and no tax cuts for the middle class by not proposing any specifics.  The reality is that the Romney-Ryan plan is just politico-wishspeaking:  there is no plan that will do what they claim, because they depend on the now-well-disproven idea that huge tax cuts for the wealthy will generate more tax revenues while creating more jobs.  Nope.  Neither likely nor even possible.  And by not specifying what they'd cut, they are merely trying to fool the people.

Here are what Romer proposes, with some commentary:

1) tax credits for businesses that actually increase employment

Not a bad idea to replace the endless suggestions of business tax cuts, but any accountability will have to be long-term--i.e., payroll will have to increase over a period of 2 years and the particular jobs created will have to stay in place for at least 2 years before any tax reward should be available

2) "well-designed tax reform that raises at least some additional revenue" and "let[s] the Bush tax cuts expire for those earning more than $250,000 a year [while] [i]ncreasing rates on top earners" and "lowering tax expenditures" including "the low tax rate on capital gains and dividends"

Hmmmm.The clarion call for tax reform has consistently been used by DC lobbyists to push for tax CUTS for the wealthy and big business.  It is not so clear that we need a huge tax reform.  What is usually meant by tax reform is "simplification," which is just another way to justify unneeded tax cuts  .We do not need to cut the corporate tax rate.  We do not need to reduce tax regulations. 

 But I do agree with Romer's notion that we need some tax increases.  My preference would be to allow the entire panoply of Bush tax cuts--passed by a Congress that unfortunately and wrongly believed the Laffer lie that cutting taxes would increase revenues--to expire as the Republicans originally purported to intend.  Let the sunset happen.  And then come next year, think about what, if any, of the cuts make sense. Perhaps a cut to the income tax rates of those who make less than $100,000 a year.  But an increase for those that make more than that, and a significant increase for the top two quintiles, would be in order.  We should raise rates on the wealthiest by creating additional tax brackets for those making 500,000 to a million, 1-2 million, 2-10 million, and above 10 million.   We could reasonably examine the many tax expenditures/subsidies in the Code and begin to cut back on them--starting with the capital gains rate preference, and moving through the exorbitant support for wealthy mortgages (limit it to an interest deduction on the first $250,000 of mortgage interest and phase that out for anyone with an income above $500,000) and including the R&D credit (rather than deduction), the "active financing exception" and the subsidy for moving active businesses offshore (and along with that, eliminating any idea that there is such a thing as a "profits" partner who isn't taxed on a "transfer" of a partnership interest at the time the interest is provided).

3) slowing spending growth for government health care spending- by reducing overpayments to health care providers (as the $716 billion cut misrepresented by the GOP does); by increasing those cost-cutting reforms to find other ways that we are inefficient; by "making the wealthy pay a larger share of their Medicare costs and gradually raising the Medicare eligibility age"

Here we see the problem that no one in government dares to say what must be said--that until we move to a single-payer system like the rest of the advanced world, we will see private parties continuing to rip off rent profits from providing health care.  We must eventually expand to "medicare for all"--and we should do that soon.  In the transition, it would be reasonable to have a means-adjusted payment scale, so that the Medicare tax is higher for those with more income (corresponding to the increased brackets for the income tax).  And it might be reasonable to have a few major categories of jobs for determining base retirement age--workers in steel plants who work in 115 degree interiors when it is 90+ degrees outside likely should retire earlier than workers in academia who work at their desks in air-conditioned offices.  But that won't be easy and will need to be developed by consensus over some reasonable time, rather than through partisan, anti-worker politics.

4) cut other spending--protecting children, displaced workers, and wounded veterans in the process,as well as money for education (including Pell grants) and infrastructure and scientific research--but cutting "agricultural price supports and subsidized crop insurance programs that mainly benefit large commercial farmers," the Pentagon's budget, and high-speed rail.

We certainly can cut a lot of waste and warmongering out of the Pentagon's budget, which is one reason that I'm all for letting the sequester approved by Republicans go through.  We could save a great deal there that could be used for infrastructure and other spending that builds opportunities and jobs instead of supporting the military-industrial complex.  I'd also support  cutting most of the agricultural subsidies, which primarily support Agribusiness that produces tasteless food at a high environmental cost.  But I disagree strongly on high-speed rail.  If we don't as a nation invest in transportation infrastructure that moves us beyond the costly highways (costly in human lives, dollars to build and maintain, and environmental degradation), we will not advance our economy as we must.

 

Romney and Private Equity's Questionable Schemes for Paying Very Little Tax

Presumably any American who wants to be informed is aware that GOP presidential candidate Mitt Romney's claim to business acumen resides in his experience at a private equity firm that made much of its money by ramping up debt at purchased firms and using that debt to repay whatever (usually relatively small) investment the equity firm partners made in what has come to be known as "LBO" deals (for "leveraged buyout").  In LBOs, the equity firm investors almost always do well to exceedingly well, using mostly other people's money. 

Not so generally for the workers in the bought-out company.  The "rent" profits of the equity firm are often on the back of the workers, who may get fired in favor of outsourcing their jobs or get stuck in a rut, as productivity gains go to the new managers and owners and not to the workers.  At the least, the high debt load makes it very difficult for the company to succeed and certainly difficult for it to give its workers a fair shake.   Remember that one of Romney's gaffs was to admit that he enjoys firing workers.

Why anybody thinks this kind of winner-take-all, leverage-'em-up mentality of private equity firms suggests the kind of leader desirable for a democracy that purports to provide genuine opportunity for all classes of citizens to live a decent life is beyond me. 

But even if the very nature of the business and the common tools of over-leverage and "rent" profits for a very few already at the top don't give voters cause for pause, then there are the many ways that private equity firm partners manage to avoid paying their fair share of taxes, which ensures that more of the tax burden falls on the less-well-off, that are worthy of consideration, even if candidate Romney has not (as his campaign claims) benefited from them personally.  That is because if Romney is elected president, his views on the acceptability of aggressive tax strategies of questionable legality will matter.  We should know what kinds of tax schemes are routine in the business that he touts as good evidence of his ability to serve as president of this nation--especially if some of them are obviously poor policy (the carried interest treatment) or highly questionable tax avoidance schemes (the management fee conversion waiver scheme).

I. Carried Interest

The best known way private equity firm partners reduce taxes is by earning their compensation in the form of "carried interest" and claiming that such profits should be treated the same way a real capital investment in a partnership is treated, even though it is awarded as compensation for their purported management expertise and work and not as a return on an actual investment made.   That is, they claim they are profits partners in the firm and that their compensation is a distribution of the partnership's profits (usually from gains on sales, and hence eligible for preferential capital gains) to them rather than compensation income.  As such they benefit from the extraordinarily preferential rate for capital gains in the current law as enacted under the Bush administration (generally 15%).  Carried interest is the primary reason that candidate Romney has to pay such a very low rate of taxes on his income from his business.

The Internal Revenue Code (the codification of the federal statutes governing the federal income tax) does not include a specific provision governing profits interests and indicating that such "profits" partners should be treated as actual partners in a partnership (without that partnership interest itself being subject to tax as compensation) entitled to receive capital gains distributions.  Accordingly, as one partnership tax treatise puts it, the tax treatment of a transfer to a "service partner" of a "profits interest" for services "has been uncertain" because "[n]o provision of the Code specifically exempts from taxation the receipt of any partnership interest in exchange for services."  Willis & Postlewaite, Partnership Taxation, 6th ed, at 4-124.    There is some caselaw about profits interests, but those cases made it even less clear how and when such interests should be taxed. 

Finally, the Service resolved the issue with administrative authority (heavily lobbied for in the interests of equity partners and real estate profit partners, in particular) in Rev. Proc. 93-27 (and later proposed regs and other items) that does not treat the issuance of a compensatory "profits interest" as  a taxable event in most instances.  The main reason for the treatment may well be the so-called "Wall Street Rule"--once incredibly wealthy taxpayers hire sophisticated, high-priced lawyers to produce opinons supportive of a taxpayer-favorable interpretation and then operate as though the Code blesses a particular activity, it is hard for tax administrators to issue regulatory authority that treats that activity differently.

2, Management Fee Conversion Waivers

But there is another lesser-known aspect to the compensation that private equity fund partners earn for their services in their private equity firms--the management fee.  Most explanations describe this as  compensation paid for services that is subject to taxation at the ordinary rate (just like a secretary's wages would be).  But that disregards a practice that exists among a significant number of equity firms (the Times article linked below says about 40% in 2009) that are willing to take aggressive positions to avoid paying taxes and can afford to pay the tax professionals to provide a way to do it--the management fee waiver conversion scheme. 

The conversion of management fees from ordinary income to capital gains is purportedly accomplished by "waiving" the fees (not necessarily across-the-board throughout the life of the firm, but often selectively and on a quarter-by-quarter basis),  Instead of getting fees, the partner claims they are "converted" to a share of related profits --i.e., they become an additional carried interest--and hence eligible for treatment as (deferred) capital gains from the firm.  

Some tax professionals think this conversion waiver works.  Much of this is again the "Wall Street Rule"--the claim that lots do it, the IRS has known about it, and oh it should be justifiable because now the "fee" is (sort of, maybe, kinda) at risk.  It is not really at risk in the way we ordinarily think of investment risk, since these are pre-tax dollars -- the managers are not putting after-tax dollars at risk like any other investor is doing.  And as Vic Fleischer commented to the gothamist blog, "there is a tension between economic risk and tax risk .... The way Bain set it up there's not much risk at all, so it's hard to see how this income should receive capital gains treatment."  Christopher Robbins, NY AG: Bain Capital and others may have skirted tax law, the Gothamist (Sept. 2, 2012).  

I'd guess  that most professionals do not think the conversion scheme works, at least not in most instances.  This would be especially true for those who consider that interpretations of the law should further coherent bodies of law that work as fairly as possible.  And even more tax professionals likely think that the partnership rules should be adjusted to ensure that it doesn't work, since otherwise we are perpetuating inequities in the tax system that favor the already incredibly rich.

The conversion waiver issue has come to the attention of the public now because the New York State attorney general is investigating private equity firms who may have engaged in this conversion waiver practice.  See Nichnolas Confessore et al, Inquiry on Tax Strategy Adds to Scrutiny of Finance Firms, New York Times (Sept. 1, 2012) (noting that the AG's subpoenas, issued by the AG's Taxpayer Protection Bureau, cover firms like Kohlberg Kravis, TPG Capital, Apollo Global, Silver Lake and Bain, and that Bain partners may have saved more than $200 million in federal income taxes, $20 million in Medicare taxes). 

It's not clear on what grounds the New York AG is investigating this issue, which appears on the surface to be primarily a federal income tax issue.  It could be some sort of state-law fraud claim but it could also be a claim that underpayment of state taxes routinely results from the filing posture taken,  Equity partners in firms using the conversion waiver would presumably be able to save on state income taxes through either rate preferences and/or deferral, depending on the state and how much the state's laws build on the federal filing.  Though New York State does not have a preferential rate for capital gains, if the timing of reporting the income is set by the conversion waiver, the deferral would amount to a significant state tax savings that deprives New York of needed revenues. 

[Aside:  By the way, some of the information about the management fee conversion waiver first came to broad public attention in connection with Bain and the trove of documents released at Gawker.com.  See John Cook, The Bain Files: Inside Mitt Romney's Tax-Dodging Cayman Schemes, Gawker.com (Aug. 23, 2012) (noting that the huge cache of Bain financial documents "shed a great deal of light on those finances, and on the tax-dodging tricks available to the hyper-rich that [Romney] has used to keep his effectie tax rate at roughly 13% over the last decade").   These documents, and the further analysis articles available at the Gawker.com site, are worth considering for their own revelation of what Romney's real business is like and how that does (or doesn't) suggest he can help our economy as president--it is a business where "opaque complexity" allows the "preposterously wealthy" to engage in "exotic tax-avoidance schemes", according to the Gawker.com article.  (I have not yet personally perused much of the 950 page trove on Gawker.)  That said, Romney's campaign issued a statement indicating that the candidate has not benefited from the conversion waiver practice.  We have not, of course, seen enough of Romney's tax returns and supporting information to be able to judge this matter independently.  The focus on the conversion waiver thus provides yet another reason why candidate Romney should release 10 years of tax returns as other candidates have done.]

There are two additional readable pieces on this conversion waiver issue, plus a scholarly article that anyone wanting to better understand the details can peruse.  Vic Fleischer, a tax prof at Colorado who made his original contribution to academe by writing about carried interest, has an article that sets out the issues well, with an example contrasting the significant difference in after-tax results for a real investor compared to a profits-interest purported investor.  See Victor Fleischer, What's at issue in the private equity tax inquiry, DealBook, New York Times (Sept. 4, 2012). See also Brian Beutler, Did Bain Capital Execs Break the Law Using a Common Tax Avoidance Strategy? Talkingpointsmemo.com (Sept. 3, 2012). The academic piece is Gregg Polsky, Private Equity Management Fee Conversions (Nov. 4, 2008).  The following two paragraphs are from the conclusion to that piece.

In fact, there are strong arguments that it is not. While managers argue that the safe harbor in Rev. Proc. 93-27 applies to the additional carried interest, there are both technical and conceptual claims to the contrary. Without the protection afforded by Rev. Proc. 93-27, the additional carried interest would be taxable upon receipt if it has a market value capable of determination. Both the context in which the additional carried interest is issued and the specific design features of the typical additional carried interest support the view that additional carried interests are significantly easier to value than prototypical profits interests.Under existing caselaw, this would mean that the additional carried interest is taxable upon receipt as ordinary income to the extent of its fair market value.

The IRS also has strong arguments under section 707(a)(2)(A), which recasts transactions that are artificially designed as partnership transactions in order to obtain tax benefits, such as character conversion. In the context of fee conversions, the most critical fact that favors section 707(a)(2)(A) recharacterization is the manager’s very limited exposure to risk. As a result, section 707(a)(2)(A) likely applies to fee conversions. If so, the manager’s attempt to convert the character of their management fee income would be thwarted.