Carried interest and Swiss cheese

Larry Ribstein —  24 June 2010

When I last wrote on the carried interest debate I commented on the NYT’s Andrew Sorkin’s support for characterizing private equity managers’ carried interest as ordinary income rather than capital gains. This is supposed to be a simple change that cuts fat cat fund managers down to size and fairly distinguishes what is essentially compensation for managing a business, just like executives’ stock options, from investment income. But what if the distinction isn’t all that straightforward? I noted that

the fund managers are getting paid for the same sort of acumen or luck that underlies any successful stock market investing.  Why should it matter that they happen to be investing through a partnership, essentially borrowing from the investors and paying them interest in the form of the substantial share of the gains the investors get to keep?  * * * Of course none of these nuances matter if what you really want to do is to punish rich capitalists. 

I also observed that on policy grounds it makes no sense to target this efficient form of compensation. And more ominously I previewed the horse-trading that would accompany this supposedly straightforward change:

The high-powered compensation that Congress is considering attacking is common in venture capital and real estate, two industries whose health is important to any recovery.  * * * If they win their carve-outs, the new tax looks more like Swiss cheese than a return to economic reality. In general, this whole thing looks a lot more complicated than Sorkin would have us believe.

Today’s WSJ makes that clearer:

[The tax change] would be a huge hit to the estimated 6.5 million folks invested in real-estate partnerships, who own assets ranging from a local house to a commercial shopping center. The legislation also potentially hits any partnership invested in certain specified assets, including families who own, say, an auto dealership, fishing boat, construction company or securities. * * *

[B]ecause Democrats chose to target individuals who provide “investment management services,” and because this definition can easily encompass individual family members who manage family projects, entire partnerships could be subject to the higher taxes. Even worse, the higher rates would apply not only to investment gains, but to any gains from the sale of the partnership itself. So the provision would deny families the ability to sell their business at the normal capital gains rate. * * *

Democrats understand this problem, which explains why the House version included a specific carve-out for family farms and ranches held in partnership. The other family partnerships were told to sit back and let the Treasury Department clarify the legislation—and exempt them—via regulation. But if this tax hike is supposed to be about equitable treatment, why exempt some partnerships but not others? * * *

Democrats are rewriting a half century of partnership tax law with no hearings, no analysis and little debate. And they wonder why businesses are creating so few jobs.

In other words, it’s increasingly obvious that this change was never really about fairly treating like income alike but about fleecing fat cats. Indeed, I speculated three years ago that the move was just a way to gin up campaign contributions. Whether or not there was really any theoretical basis for taxing carry like ordinary income (and I’ve been skeptical) mattered little when the proposal got to the Congressional sausage factory. And now we find that it’s not so easy to target the fat cats without causing considerable collateral damage or ending up with even less defensible distinctions than we started with.

Maybe this carried interest move wasn’t such a great idea after all.

Larry Ribstein

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Professor of Law, University of Illinois College of Law