Related post: The Blackstone IPO: Regulatory Arbitrage
Blackstone's S-1 describes an intriguing tax structure, and it promises a tax opinion from Simpson Thacher. It looks like it probably "works." Given the current DC political climate and hunger for revenue offsets, however, and the likelihood that Congress will take a hard look at the taxation of private equity funds, the tax risk is significant. Analysis follows after the jump.
As I discussed last week, Blackstone's IPO structure takes an aggressive tax stance.
Background. By operating in partnership form, private equity funds take advantage of a quirk in the tax law that allows fund managers to receive compensation in the form of equity taxed at long term capital gains rates (15%) instead of ordinary income rates (35%). The partnership form also allows the asset management aspect of the operation to take place without incurring an entity-level corporate tax. Private equity funds also want to avoid operating as RICs (regulated investment companies), which get pass-through taxation but subject the firm to the restrictive regulation of the Investment Company Act of 1940. Publicly-traded entities are normally taxed as corporations; accessing the liquidity of the public equity markets usually requires paying a steep toll charge in the form of an entity-level tax.
The tax issue. Blackstone elegantly finesses this tax problem by trying to qualify to an exception to the publicly-traded partnership rules (section 7704) for entities that earn "passive-type income." Normally, publicly-traded partnerships are taxed as corporations, regardless of how they are organized under state law. Section 7704 carves out exceptions for partnerships with "passive-type income," which include interest, dividends, real property rents, certain oil and gas activities, and gain from the sale or disposition of most capital assets. The exception thus distinguishes passive investment activities, for which pass-through treatment is appropriate, from the operation of an active trade or business, for which it's not appropriate.
What's at stake. Failing to qualify for pass-through treatment wouldn't be fatal to Blackstone's future. But it would hurt. A lot. It would lose two key tax advantages: (1) the capital gains preference on carried interest distributions, which I address in Two and Twenty, and (2) the ability to pass income through to investors without incurring an entity-level tax. Blackstone's impressive IRRs depend, in part, on the availability of these tax preferences.
Suppose a Blackstone fund buys a portfolio company for $100 million and sells it five years later for $200 million. It's 20% carry is worth $20 million. If it's a partnership, then investors pay tax on a pro rata share on that $20 million at 15% capital gain rate, and collectively take home $17 million. If it's a corporation, the corporation first pays tax on that $20 million at 35%, leaving $13 million; shareholders then pay another 15% tax on the dividend distribution, leaving about $11 million. $6 million goes to the government instead of investors ... that's a huge difference.
Does it look like a duck? Drawing the line between corporations and partnerships has always been a challenge. In the old days, entity classification depended on a four-factor test of limited liability, continuity of life, centralized management, and free transferability. (Under the old test, then, it's obvious that a publicly-traded Blackstone would be treated as a corporation.) Under the check-the-box regs, however, unincorporated entities may elect whether to be taxed as a corporation or a partnership. Section 7704, however, serves as a backstop to the check-the-box regs, ensuring that publicly-traded active businesses can't elect out of corporate taxation. The normative justification for taxing some entities like corporations but not others is pretty fuzzy. All we have as a guiding principle is the "corporate resemblance" test derived from an old 1935 Supreme Court case, Morrissey vs. Commissioner. In colloquial terms, if it walks like a duck and quacks like a duck, it should be taxed like a duck. (Although Minnesota tax prof Gregg Polsky has raised concerns about the validity of the check-the-box regs for failing to faithfully apply the resemblance test, my own view is that the regs are valid as a matter of institutional deference to a reasonable agency interpretation of the Code.) In any event, a publicly traded Blackstone sure quacks like a duck, so a careful reading of 7704 is in order.
Passive-type income. To retain its partnership tax status, Blackstone will have to avoid classification as a publicly-traded partnership under section 7704. Section 7704(c) makes an exception for publicly-traded partnerships with at least 90% passive-type income, which includes interest, dividends, and gain from the sale or disposition of a capital asset. Most of Blackstone's income comes from carried interest distributions. These distributions, in turn, are generated by the sale of portfolio companies held by the underlying Blackstone funds. Do these distributions qualify as passive income? It appears so. Section 7704(d)(1) lists the different types of qualifying income, including 7704(d)(1)(B), dividends. Portfolio companies generate dividends. Under the plain language of 7704(d)(1)(F), then, carried interest distributions would appear to be "gain from the sale or disposition of a capital asset ... held for the production of income described in any of the foregoing subparagraphs or this paragraph ...."
Still, Blackstone may not be home free. First of all, the tax status depends on not being treated as a regulated investment company, which in turn relies on a delicate 40 Act interpretation. Second, there's a pretty strong argument that it's violating the spirit of the rules, and non-textual arguments have special force in the tax context.
Legislative History. The House explanation in the legislative history explains that the purpose is to distinguish "those partnerships that are engaged in activities commonly considered as essentially no more than investments" and "those activities more typically conducted in corporate form that are in the nature of active business activities." Passthrough treatment is appropriate if the partners could "independently acquire such investments." Public investors, of course, can't normally independently acquire an investment in Blackstone.
The House report goes on to explain, in the context of interest and rents, that amounts contingent on profits are not intended to be included as passive income. Interest that's contingent on profits "involves a greater degree of risk, and also a greater potential for economic gain," than fixed or market-indexed interest rates, "and thus is properly regarded as from an underlying business activity." Carried interest distributions are obviously contingent on profits -- the profits of the underlying fund. But they are a step removed from the underlying business activity of the portfolio companies, so it's not clear that this is improper.
More to the point, perhaps, the House report then explains that interest isn't passive if it's derived in the conduct of a financial or insurance business, such as an active banking business. The key question, then, is whether the management of the underlying funds is an active business.
What about those management fees? Fund managers derive income not just from carry, but also from management fees, advisory fees, break-up fees, and other streams of income that would be difficult to characterize as passive. Regulation 1.7704-3(a)(2) explains that qualifying income does not include income derived in the ordinary course of a trade or business. "For purposes of the preceding sentence, income derived from an asset with respect to which the partnership is a broker, market maker, or dealer is income derived in the ordinary course of a trade or business; income derived from an asset with respect to which the taxpayer is a trader or investor is not income derived in the ordinary course of a trade or business."
A private equity fund manager isn't a broker or a dealer ... but neither is it a trader or investor, at least in the usual sense. What is it? It's an active financial intermediary, for which we have no established tax classification. The receipt of management fees and other fees that don't depend on the profitability of the underlying portfolio companies is pretty clearly active income. The receipt of carry is something closer to investment income.
To solve this problem and slip into the 90% qualifying income exception, Blackstone will siphon off its "bad" income (management fees, etc.) into a separate entity that elects to be taxed as a corporation. The blocker entity pays tax on the ordinary income. That entity will then pay dividends to the master partnership. The master partnership then has two primary sources of income: (1) dividends from the blocker entities, and (2) capital gains from carried interest distributions from the underlying funds. Since dividends are qualifying income, and since carry is income derived from the sale of a capital asset, all is well.
Or is it? Blackstone, like many businesses, derives income from a mix of ordinary income and capital gains. In the aggregate, it's difficult to characterize what Blackstone does as pure passive investing. Blackstone finesses the tax treatment by paying corporate tax only on the ordinary income, and passing through the rest of the income without paying an entity-level tax. This creates a significant competitive advantage compared to investment banks like Goldman Sachs and Morgan Stanley, which are structured as corporations and pay an entity-level tax on all of their income.
I'm not sure, as a matter of tax policy, that we should allow complex tax structuring to provide this sort of competitive advantage. As I explain in Two and Twenty, most funds are pretty aggressive about converting management fees into special allocations of carry. Moreover, even if some "bad" income is siphoned off, that doesn't change the essential character of what fund managers do. And that's pretty difficult to characterize as passive investing.
Think about it this way. Pass-through treatment is appropriate for passive investment vehicles where fund managers are just sourcing and screening investments. Most mutual fund managers don't try to take an active role in the governance of the underlying company that their investors put money in. At most, they apply indirect pressure on management. But private equity fund managers do much more than that - they create alpha. They sit on boards, restructure portfolio companies, fire managers, spin-off divisions, streamline operations, create new jobs --- this is not passive investing. Investors would be crazy to pay the kind of fees that fund managers earn if all they were doing was picking stocks.
And Blackstone doesn't help its case by arguing, in the context of the 40 Act, that it is indeed an active business. As I noted in my last post, Blackstone argues in the context of the 40 Act that the "primary source of income from each of our businesses is properly characterized as income earned in exchange for the performance of services." Service income, not investment income. Active income, not passive income. Now, it's certainly plausible that Congress intended active financial intermediaries to be treated as active for purposes of the 40 Act and passive for purposes of the tax code. The tax code tolerates a fairly high degree of planning, such as when REITs siphon off "bad" income into a blocker entity. But when this sort of regulatory arbitrage promises to significantly diminish corporate tax revenues, Congress is likely to revisit how the rules are written.
At the end of the day, I think Blackstone is violating the spirit of the rules. I'd be surprised if Congress didn't agree. Still, since carried interest distributions are income derived from the gain derived from the sale of a capital asset, the language of the existing statute may be enough to carry the day, for now. It's certainly appears to be enough to justify the S-1 filing and the tax opinion from Simpson that will accompany it.
In sum, under current law there's some tax risk that the IRS will challenge Blackstone's claim to the "passive-type income" exception to the publicly-traded partnership rules. The greater risk, I think, is that Congress may change the rules. Tomorrow: The politics of taxing Blackstone.
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