Tax Blog/Blawg

Editors’ note.  This is the first of a new periodic series on the Tax Blawg.  Mainstream press articles often implicate complex, technical tax issues.  Admirably, the press attempts to simplify the tax issues to make them more interesting and digestible for the general public, but sometimes simplification can leave readers with an incomplete or misleading understanding of the big tax picture.  For that portion of the audience who wants a little more background than the mainstream press can realistically provide, this series will unwind the tax issues discussed in prominent news articles.   

Yesterday, the New York Times published a thorough investigative report about the compensation that Mitt Romney continues to receive thirteen years after he left Bain Capital.  The report suggests that the tax law provides private equity managers like Mr. Romney favorable tax treatment not available to the rest of us:

But since Mr. Romney’s payouts from Bain have come partly from the firm’s share of profits on its customers’ investments, that income probably qualifies for the 15 percent tax rate reserved for capital gains, rather than the 35 percent that wealthy taxpayers pay on ordinary income. The Internal Revenue Service allows investment managers to pay the lower rate on the share of profits, known in the industry as “carried interest,” that they receive for running funds for investors.

“These are options that are not available to the ordinary taxpayer,” said Victor Fleischer, a law professor at the University of Colorado who studies financial firms. “You continue to take your carried interest — a return on labor, not capital invested — and you’re paying 15 percent on it instead of high marginal income rates.”

In a vacuum, the Times’ assertion appears scandalous.  Is it true that private equity managers receive preferential tax treatment on their labor income compared to the middle class?  Well, yes and no.  Managers in Mr. Romney’s industry sit in a “sweet spot” at the intersection of two fundamental tax regimes: the pass-through taxation of partnerships and the preferential capital gains tax rate.  Everybody sitting in that same sweet spot would receive the same favorable tax treatment.  In that regard, despite what the Times’ report suggests, the tax law treats everybody exactly the same.  On the other hand, only a handful of careers create the character of compensation and provide their practitioners the type of flexibility necessary to position themselves in the sweet spot.  And, practitioners in those careers – like private equity managers – tend to become very wealthy.

To better understand the sweet spot, we need to explore the fundamentals and policy underlying partnership and capital gain taxation, as well as their intersection.  For our readers immersed in the tax law on a daily basis, some of this is probably review.

Partnerships.  The policies at the heart of partnership taxation reflect their treatment under the common law.  In contrast to corporations, the common law viewed partnerships as contractual relationships between their owners instead of separate legal persons.  Accordingly, since its 1913 enactment, the tax law has treated partnerships as aggregates of their partners acting in their individual capacities.  So, unlike corporations, partnerships do not pay tax.  Instead, the tax consequences of their transactions pass through to their partners – so-called “pass-through taxation.”

Private equity managers organize their firms as partnerships.  So, fundamentally, while thinking about Mr. Romney’s taxes, we should remember that the pass-through taxation regime applies.  He is treated as doing whatever Bain Capital does and pays taxes on the portion of Bain Capital’s profits that it allocates to him.  Further, in operating their business, private equity firms create “funds,” which are themselves generally (but not always) partnerships, and which consist of capital invested by large passive investors, like pension funds.  If you’re following along, that means Mr. Romney is a partner in a partnership (Bain Capital) that is a partner in a partnership (a private equity fund).  This “tiered partnership” structure adds a level of complexity, but the tax treatment flows through in a sort of transitive property.  Mr. Romney is treated as doing whatever Bain Capital does, and Bain Capital is treated as doing whatever its funds do, so Mr. Romney is also treated as doing whatever the funds do.

Capital Gain Preferences.  But what is it that Bain Capital and its funds do?  The funds buy operating companies - mostly corporations - nurture them to better profitability, and sell them for a profit.  The passive investors invest in these funds because they think that Bain Capital and its managers are good at turning a profit.  It is important for Mr. Romney’s tax position that these operating companies are organized as corporations; if they were partnerships, as explained above, Mr. Romney would be treated as operating their business and would likely incur ordinary income from their operations.  Because they’re corporations, though, they’re treated as a separate legal person and neither their business activities nor their income pass-through the tiered partnership structure to Mr. Romney.

The middle class buy and sell companies, too, just not on the same scale.  The share of stock owned by an IBM shareholder represents a unit of ownership in the company (probably an infinitesimally small unit, but a unit nonetheless).  Assuming he holds his share of stock for more than one year, the shareholder’s gain from selling it is taxed at favorable capital gain rates, currently no more than fifteen percent.  As explained above, if Bain Capital buys and sells shares of corporate stock, which are capital assets, it passes through the tax consequences of these transactions to its partners.  Accordingly, its partners are taxed at favorable capital gain rates.  (Actually, many private equity investors are tax exempt entities or foreign persons, both of which are generally not taxed at all on capital gains.)

Much ink has been spilled over whether these preferential capital gain tax rates should exist, but they have been a feature of the tax laws since 1921.  Supporting their existence, capital gains rates ameliorate the otherwise punitive aspect of double taxation of corporate income.  Theoretically, they also encourage the investment of capital, thereby helping grow our economy for the common good.  Finally, because taxpayers do not pay tax on unrealized appreciation (i.e., an increase in the value of an asset while it is held), subjecting a taxpayer to ordinary income tax at disposition could subject him to a huge tax bill.  On the other hand, preferential capital gains rates value capital over labor.  And, as noted in the Times report, they also tend to benefit the rich, like Mr. Romney, more than the working class because the rich receive a larger percentage of their income from passive investments.

The Sweet Spot For Service Partners.  Combining pass-through taxation and capital gains preferences yields a very favorable result for private equity managers.  As we’ve discussed, Mr. Romney is treated as engaging in Bain Capital’s activities and the firm passes through a portion of its capital gains to him which are taxed at preferential capital gain rates.

However, as many pundits and politicians object, private equity managers are not passive investors.  During his tenure at Bain, Mr. Romney labored to provide his private equity investors a service: analyzing and buying companies, nurturing those companies to enhance their profitability, and finding a buyer willing to purchase them at a handsome profit.  So, the argument goes, just as the average Joe pays taxes at ordinary income rates on his service income, so should Mr. Romney.

Further supporting this argument, in many cases private equity managers put up none or very little of their own capital into the funds they form to acquire companies.  Initially, many funds acquire their capital from passive investors, and the private equity firm actually managing the venture only receives its partnership interest out of the partnership’s profits.  This looks more and more like compensation.  The passive investors are simply paying a portion of their profits to their investment manager.  If they did this by contract instead of by forming a partnership, then the passive investors’ compensation to Mr. Romney for managing their money would be taxable as ordinary income.  By forming a partnership, however, they create the sweet spot and convert what would be compensation income into what the press usually refers to as a “carried interest” or “profits interest,” through which capital gains flow.

Courts, the IRS, and Congress have each grappled with this very issue.  Courts and the IRS have recognized that a carried interest has compensation-like characteristics, but they have generally respected the partnership form of the arrangement.  See Rev. Proc. 93-27, modified by Rev. Proc. 2001-43; Diamond v. Comm’r, 56 T.C. 530 (1971); Campbell v. Comm’r, 943 F.2d 815 (8th Cir. 1991).  The courts arrive at this conclusion for a practical reason.  Unless the service partner sells his profits interest soon after receiving it, its market value is difficult to ascertain and its liquidation value, by definition, is nonexistent.  So, the theory goes, the administrative burden of taxing it on receipt would likely outweigh the resulting revenue.

Several times in the last few years, however, proposed legislation has sought to reverse this result.  Under the proposed legislation, service partners’ distributive shares would be taxed as ordinary income, except to the extent attributable to their invested capital.  In fact, in 2009 and again in 2010, the House of Representatives passed versions of this legislation, only to see them die in the Senate.  Through several legislative machinations, the various versions of the carried interest legislation attempt to single out private equity and hedge fund managers while keeping pass-through taxation the rule for other service partners.  For instance, one version of the legislation applied only to statutorily defined “investment services partnership interests,” which included those owned by partners who engaged in activities strongly resembling the activities carried on by Mr. Romney’s contemporaries.  Another version, demonstrating Congress’ omnipresent concern for the family farm, made sure to exempt service providers who were partners in family farms from the legislation’s reach.

A small irony can be seen by juxtaposing the carried interest legislation with the New York Times’ report.  The Times suggests that private equity managers receive preferential treatment through their special treatment under the tax law.  However, in reality, private equity managers actually achieve a favorable tax result not because the tax law treats them specially but because it treats them the same as everybody else.  To change this favorable result and tax their labor income as some contend it should be, it would take an act of Congress to treat them especially and uniquely bad.