This is the second in a two part series on hedge fund taxation. In the first post I explained how it is that hedge fund managers are rewarded for their work with capital gains rather than ordinary income. I indicated that the benefit does not come from special rules peculiar to their industry, but rather from fundamental principles of partnership taxation. Subchapter K is not a breakfast cereal by the way. The K, I’m referring to, which includes sections 701-777, is a Subchapter of Chapter 1 (Normal Taxes and Surtaxes) of Subtitle A (Income Taxes) of Title 26 (Internal Revenue Code) of the United States Code. It is about “Partners and Partnerships”. It seems like it should be simple. A partnership does some business. There is income and deductions, credits whatever. All of those items get distributed among the partners. What’s hard ?
Well there is a lot that is hard. The major source of complexity comes from the ambiguous nature of partnerships. This is described in McKee, Wilson and Whitmore’s Federal Taxation of Partnerships and Partners as the aggregate and entity concepts:
Subchapter K represents a blending of two views as to the nature of partnerships. The first view is that a partnership is simply an aggregation of individuals, each of whom should be treated as the owner of a direct undivided interest in partnership assets and operations. This is sometimes referred to as the “aggregate” or “conduit” view of partnerships. The second view is that a partnership is a separate entity, with a tax existence apart from the partners. Under this view, a partner has no direct interest in partnership assets or operations, but only an interest in the partnership entity separate and apart from its assets and operations.
If you ever want to impersonate a partnership expert be sure to mentionMcKee a lot, say that you are talking about Subchapter K rather than saying you are talking about partnerships, when faced with a knotty problem mumble to yourself random three digit numbers beginning with 7 and never say “negative basis“, without grimacing.
What is So Special About Hedge Fund Managers ?
The favorable treatment that hedge fund managers have comes from the entity approach. As partners they are allocated partnership income. You don’t look at what the manager did. You look at what the partnership did. What did the partnership do ? The partnership invested. What do you get when you sell an investment ? Capital gains. So some people got together. Some of them put up money. Others decided where to put the money. The entity had gains. The taxable results determined at the entity level were apportioned among the members based on the economic benefit they received. OK but there is something nasty about hedge fund managers so there should be a law so they don’t get capital gain treatment. The fact is I have low expectations about taxes being fair, reasonable or making sense. My motto is “It is what it is. Deal with it.” Go ahead, have a party, screw the hedge fund managers. I had a question though. How are they going to do that ?
In case you want to know how to discuss this issue and sound intelligent without actually getting into any of the details of the actual law changes. Here is something from Howard Gleckman of the Tax Policy Center
If you watch the video closely you will note that there was no mention of McKee, no three digit numbers beginning in 7, no mention of Suchapter K. He is not even pretending to know about partnership taxation. Seems like a nice enough guy, but he probably thinks that there is such a thing as negative basis.
Ask the Answer Man
I know a good bit about partnership taxation, have decent research skills and excellent research tools. So I rarely call somebody up when I have a question. This particular question I needed to call somebody. The reason is that I avoid deep study of proposed legislation. Now that I’m a Forbes blogger, I may have to alter that, but deep study of proposed legislation is dangerous for someone with my day job, because I might confuse something that is proposed with something that has been enacted. So a question like this or some other very obscure question I usually callCharley Egerton. Usually the first thing he says is “Did you check McKee?” This time he didn’t.
Charley is an Orlando tax attorney. Calling Charley a tax attorney is a bit of an understatement. Charley just finished up his term as Chair of theAmerican Bar Associations Tax Section. Previously he had chaired theABA Tax Section’s Committee on Partnerships and LLC’s. So Charley is a tax attorney’s, tax attorney’s, tax attorney. When he has a question he probably doesn’t check McKee. He probably calls him. God knows McKee should give him a cut of his royalties.
Here is how I framed the question:
If you try to fix it so that “hedge fund managers” don’t get capital gains treatments on their “carried interests” is that going to affect all sorts of other partnerships in an unpredictable and complicated manner ?”
His answer to my question (and I’m quoting him now) was “Yes.” (Maybe more like “YES!”). He pointed me to the proposed legislation.
Oh To Be Young Again
In order to fix this perceived problem with hedge fund managers, a new section will be added to the Internal Revenue Code – Section 710. It runs 3060 words. Things like this usually have regulations issued. To take perhaps an extreme example 704(b) (a subsection), one of the most critical parts of the law concerning partnership income taxation, contains 88 words. The TABLE OF CONTENTS of the related regulations runs to almost 400 words. I have risked future confusion to read one version of proposed Section 710 a few times now, it seems that it has very broad applicability. I think it could reasonably apply to the managing partner of an accounting firm that does a lot of acquisitions. At any rate, there is no question that it adds a tremendous amount of complexity to an already complex field and affects a lot more people than hedge fund managers. Here is the letter that Charley sent to Congress trying to explain all that.
Some of you might think that I am somebody inclined to curry favor with hedge fund managers and venture capitalists. You have that right. You introduce me to somebody with a stack of complicated partnership returns that they are willing to pay standard rates to get done. Well. I’ll kiss your ass in Macy’s window on dollar day or whatever the contemporary equivalent of that act would be. I’m not writing this to suck up to them, though. No, I’m actually in an idealistic mode here. As a citizen I think this legislation is a bad idea. It is an emotional response to a non-problem that will have unintended consequences. You don’t like the capital gains rates, just raise them.
Here is how Section 710 looks from the perspective of my day job. If I were twenty years younger I would be praying for this thing to pass. A whole new Code section that affects or might affect countless existing deals with no grandfather provision is fantastic. If you are a young person just starting out in the field make sure you understand 704(b). Study 752 so you will understand why there is no such thing as negative basis. The rest of it depends on what industries you are involved in. Just for the heck of it, though, dive into Proposed Code Section 710. It may turn out that you have wasted your time. If it does pass make sure you go back and study what actually passed so you are not confused by the proposed versions you looked at . Then let everybody know you are an expert on Code Section 710. It might make your career for you.
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