Effective taxation of carried interest: a comprehensive pass-through approach.

• Author: Sacks, Jason A.

1. INTRODUCTION

   Taxation of "carried interest" has been the subject of much recent scholarship. (1) Articles have discussed the unfairness of taxing carried interest differently than other compensation for services, (2) and addressed the dangers inherent in subjecting an intrinsically mobile tax base to rates higher than those presently applied to carried interest by the Internal Revenue Code. (3) Most of this scholarship, however, erroneously ignores that fund managers who receive carried interest income are often in a position to significantly impact the U.S. economy. (4) Ignoring this fact thereby forecloses an opportunity for Congress to utilize an efficient carried interest taxation regime as an instrument to promote its general economic goals, by means of rate differentials associated with policy objectives. (5)

   This Note will briefly discuss what constitutes carried interest and general tax policies and considerations. It will then discuss carried interest tax legislation recently proposed by Congress, address the legislation's shortcomings, and propose an alternative carried interest taxation regime. Lastly, it will address opportunities available to Congress for utilizing carried interest tax legislation as a means to obtain policy objectives.

   1. General Policy Overview

      Carried interest taxation can be best modified by Congressional statute. (6) Congress generally considers a number of policy objectives and considerations when enacting tax legislation. (7) The interplay between these considerations is complex, and these objectives alternately complement and conflict with each other. Because taxation is an integral part of a comprehensive fiscal policy, Congress' primary objectives should be to promote economic growth, to promote economic (and price) stability, and to raise revenue to fund general and specific expenditures. (8) In light of these objectives, some of Congress' primary tax policy considerations include administrability, promotion of taxpayer compliance, equity (including both horizontal equity and vertical equity), economic neutrality, and economic incentivization. (9) As a general proposition, it is worth noting that a tax regime should minimally impact individual decision-makers choices, unless the legislature enacting a particular tax policy specifically seeks to either incentivize or discourage specific behavior or outcomes.

      Administrability focuses on the ease with which the U.S. federal government can administer and enforce the Internal Revenue Code, and the Treasury Regulations promulgated thereunder. (10) The law, including the Internal Revenue Code, is only as effective as the government's ability to enforce it. Promotion of taxpayer compliance focuses on both dissemination of information about the tax law to the taxpayers and the burden imposed on the taxpayers in understanding and complying with the Internal Revenue Code. (11) Provisions which are excessively cumbersome or costly are often prone to noncompliance, either due to willful disregard or unintentional error. Furthermore, courts have recognized the importance of administrability and promotion of taxpayer compliance by permitting the use of estimates for certain tax deductions, notwithstanding the general burden of proof imposed upon taxpayers in disputes with the Internal Revenue Service. (12)

      Equity focuses on the fundamental fairness of a tax system. Horizontal equity and vertical equity are intrinsically related, but focus on different aspects of the overall fairness of a tax system. Horizontal equity focuses on treating similarly situated taxpayers similarly. (13) Vertical equity focuses on permitting (and sometimes encouraging) different treatment of differently situated taxpayers. (14) One of the key components of a horizontally equitable system is a focus on economic substance over legal form. Focusing on the economic substance should result in the imposition of similar tax burdens on taxpayers in similar economic positions. A key component of a vertically equitable system is a nonregressive tax structure. (15) Tax systems that are either proportionate (16) or progressive (17) may be considered vertically equitable, but many proponents of vertical equity promote progressive income tax regimes. (18) Tax systems should be considered as integrated systems. Because income taxes are only one component of an integrated tax system, (19) and because other components of an integrated tax system have different impacts on differently situated taxpayers, (20) a progressive income tax regime might be necessary to ensure that an integrated tax system is nonregressive.

      Economic neutrality focuses on avoiding "tax distortion," which is a change in a taxpayer's preferences or decisions due to a tax system. (21) Economic incentivization is the polar opposite of economic neutrality--it is the intent to encourage taxpayers to engage in certain conduct or consume certain goods (or, alternatively, to discourage certain conduct or the consumption of particular goods) by means of a tax system. (22) If an income tax is applied uniformly on all income and all income is taxed, then that tax should be somewhat economically neutral because each individual's profit-maximizing behavior will generally encourage the same conduct. However, because taxes might increase taxpayers' marginal preferences for leisure over work, or for consumption over saving, most taxes which are not uniform per capita levies will not be perfectly economically neutral. (23) on the other hand, Congress, at times, seeks to incentivize certain behaviors, such as the purchase of certain clean energy vehicles and energy efficient appliances. (24) Congress also seeks to discourage certain other behaviors, such as using corporations as personal savings vehicles or assisting unsanctioned international boycotts or storing passive income-producing assets in foreign corporations. (25) Although the tax code may seem to be something of a sledgehammer when it comes to incentivization, because it is often imprecisely targeted and may cause unforeseeable consequences, it is one of the most effective and easily-administrable means by which Congress can promote particular policies that require taxpayer buy-in. (26)

      It is also worth noting that a taxpayer is appropriately entitled to pay the lowest rate of tax imposed upon it by the Internal Revenue Code. Persons who are subject to favorable tax rates on carried interest income are not necessarily greedy or unethical; rather, some of their income is merely eligible for preferred rates under current law. As Judge Learned Hand aptly stated in Helvering v. Gregory, (27) "Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes." (28)

   2. Definition of Carried Interest & Related Background Information

      Carried interest is a mechanism employed by many investment funds to compensate fund managers for delivering strong fund-level investment performance. (29) It is generally an allocation to the fund managers of a percentage of partnership income without a corresponding interest in the partnership's capital. (30) Most investment funds are structured as either limited partnerships or limited liability companies (31) and are treated as partnerships for U.S. federal income tax purposes. (32) Accordingly, the income of the funds is subject to tax at the partner level when it is realized and recognized at the partnership level, subject to partnership-level elections. (33) Items of partnership income generally retain their underlying character when they "pass through" to the partners. (34) Allocations of partnership income, such as carried interest, are considered special allocations and retain their character when passed through to the partners. (35)

      Under current law, the receipt of a profits interest in a partnership without a corresponding capital interest generally does not result in any immediate taxation. (36) Income (both general net income and separately stated items) is computed at the partnership level; the partnership then allocates income to the partners. Each partner is taxed on all income allocated to him or her, and the character of the income is determined at the partnership level and passed on to the partners. (37) Each partner is then afforded a basis adjustment for his or her allocable share of the partnership's total income or loss. (38) Accordingly, under current law, the profits interest that entitles a fund manager to carried interest income is not taxed upon receipt by the manager, and all items of income that are allocated to the fund manager retain their initial character, as determined at the partnership level.

   3. Tax Policy Considerations of Current Carried Interest Taxation Regime

      As a matter of tax law, there are two conflicting viewpoints regarding carried interest taxation. Carried interest is generally a special allocation of partnership income. (39) Accordingly, under general partnership taxation, it may properly retain the character of its underlying source income (such as long-term capital gains, I.R.C. [section] 1231 gains, dividends, ordinary interest, tax-exempt interest, etc.). (40) On the other hand, carried interest is not merely an allocation of income between separate passive partners, but rather, it is a means of compensating managing partners for their services in managing an investment fund to achieve specific returns. (41) Many critics of current carried interest taxation focus on the fact that compensation for services rendered is generally taxed as ordinary income, and therefore, permitting carried interest to be subject to potentially preferential tax rates (including long-term capital gains tax rates) effectively provides a tax subsidy to investment fund managers. (42) From a tax policy perspective, taxing carried interest as ordinary...