June 14, 2007
The Blackstone IPO: Two and Twenty on Drugs
Posted by Victor Fleischer

Congress is considering closing the loophole that allows Blackstone to go public as a publicly-traded partnership without being taxed as a corporation.  What makes the deal so interesting is that the issues go beyond entity classification into the nature of Blackstone's income. 

I presented an early draft of my Blackstone paper at the Junior Tax Scholars Conference last weekend and received some really useful comments from Adam Rosenzweig and Alex Raskolnikov.  I won't have a chance to post the paper before the IPO closes (rumored to be the week of June 25), so I thought I'd record my thoughts in case there are any investors out there trying to assess the tax risk on the deal. 

As I discussed in grueling detail in previous posts, Blackstone squeezes itself into the "passive-type income" exception to Section 7704, which normally treats publicly-traded partnerships as corporations.  Because Blackstone earns most of its income in the form of carried interest distributions, which give rise to capital gains, and because capital gains are listed as passive income under the statute, it can fit into the passive income exception.  Active income like management fees, deal monitoring fees, breakup fees and so on are passed through a blocker entity that "cleanses" the bad income by paying a corporate level tax on that income and distributing the after-tax income up to the public partnership in the form of a dividend.  Blackstone gets two big tax breaks, then: (1) the capital gains preference on carry and (2) avoiding an entity-level tax.

Congress may simply close the loophole by repealing the passive-type income exception from section 7704.  To my knowledge, other than a few oil and gas partnerships, few investment vehicles use the exception, so little is lost by repealing it. 

It's worth noting, though, that the heart of the problem in the Blackstone deal is the tax code's treatment of carried interest distributions as capital gains rather than ordinary income.  If carry were properly treated as ordinary income, then Blackstone would have to run the income through the blocker entity and pay a corporate tax anyway.  But if carry is treated as capital gain, then it can be passed directly up to investors, who benefit from the capital gains preference. 

The Blackstone deal underscores the fallacy of treating carried interest distributions as passive income.  The deal is, as one of my discussants noted, "Two and Twenty on Drugs."  What he meant by that was that the Blackstone IPO structure takes the tax advantage of carried interest's treatment as capital gains and leverages that tax treatment into a vehicle for going public without paying an entity-level tax.  Fix the tax treatment of carry, and the Blackstone deal structure falls apart. 

Previous posts on Blackstone:

AFL-CIO vs. Blackstone

Reuters and Bloomberg on Blackstone's Tax Structure
The Politics of Taxing Blackstone
Blackstone IPO: Analysis of the Tax Risk 
The Blackstone IPO: Regulatory Arbitrage Extraordinaire

Update:  A helpful reader points out that there are more than "a few" existing PTPs.  See here.  By my count, still fewer than 100, mostly natural resources.  An handful of real estate partnerships, and of course, Fortress (the first private equity/hedge fund management company to go public using this structure).  These firms are enough to form a lobbying crew, but it's hardly a huge sector.

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