I've posted a very preliminary draft of Two and Twenty: Partnership Profits in Hedge Funds, Venture Capital Funds and Private Equity Funds.  I hesitate to post a draft that is still such a work-in-progress.  But the wily "Equity Private" (great blog, by the way) has already snaked an even rougher copy off of the UCLA website.   So long as people are reading, they might as well see my most recent version.

Besides, I need all the help I can get.  The problem is tricky enough that I've already changed my approach substantially in response to some great comments at UCLA.  So I thought I'd seek out any other interested readers while I remain flexible in my thinking. 

(A brief tangent -- Is tax the only area where scholars change their mind this much?  The wickedly-smart Mark Gergen, working on the same problem, changed his approach between 1989 and 1992 articles in the Tax Law Review.  Maybe it comes from the lack of strong priors.  Unlike Roe v. Wade, no one enters law school with a view about the proper tax treatment of a profits interest in a partnership.)

For those interested in the paper, a bit more below the fold.

In the paper, I examine the tax consequences of the industry standard "Two and Twenty" (two percent management fee and twenty percent carried interest).  The tax law allows fund managers to defer much of their income and convert some of it to capital gain.  I argue that we should adopt a modified form of accrual taxation on fund managers in large investment partnerships.  The general partner receiving the profits interest would be deemed to annually receive a cost-of-capital charge (a market rate of interest times the 20% profits interest times the amount of capital under management) as ordinary income.  The LPs would be allocated the corresponding deduction (or would capitalize the expense, as appropriate).  The cost-of-capital approach addresses the deferral issue but preserves capital gain treatment on any appreciation in the fund. 

The reasoning is as follows.  The profits interest is often compared to a call option.  But like a call option, it's also a lot like a nonrecourse loan.  (I'm indebted to Leo Schmolka and others for this insight.)  What's going on here is that the GP takes a lower cash salary in exchange for what amounts to a non-recourse, zero interest rate compensatory loan of 20% of the amount of capital committed to the fund, followed by an investment of the loan proceeds in the fund.  The proper tax treatment is to deem the GP to have received the loan, followed by an investment of the deemed amount (the difference between the market salary and the actual salary) in the fund.  The forgone interest gives rise to ordinary income, but any appreciation in the fund is properly treated as capital gain.  My cost-of-capital approach, in other words, becomes a rough justice solution on the issues of both timing and character. 

I recognize that this approach adds some complexity and clashes with our broadly-held desire to support "sweat equity" by granting favorable tax treatment to small businesses.  And so I limit my proposal to investment funds with more than $25 million in capital.  I'm targeting Wall Street, not Main Street.  I should note that, whatever the political viability of this proposal, I'm first interested in figuring out the "right" answer.  I'm interested in issues of simplification, convenience, and administrative necessity, but not (yet) interested in how the politics would play out.  At some point in the future I'll spend some time trying to figure out if a tax subsidy makes sense and if so, how it ought to be structured. 

Taxation | Bookmark

TrackBack URL for this entry:
https://www.typepad.com/services/trackback/6a00d8345157d569e200d8347d6f9e53ef

Links to weblogs that reference Two and Twenty: Partnership Profits in Hedge Funds, VC Funds and Private Equity: