Innovation and constraints on tax shelters.

• Author: O'Neill, Jessica

"General Electric [(G.E.)], the nation's largest corporation, had a very good year in 2010." (1) It reported $14.2 billion in profits with $5.1 billion coming from its operations in the United States. (2) More important than the massive profits G.E. collected are tax implications so substantial they cannot be left out. G.E. ended up paying zero dollars in taxes and actually claimed a tax benefit of $3.2 billion along with the profits it earned in 2010. (3) "While General Electric is one of the most skilled at reducing its tax burden, many other companies have become better at this as well." (4)

A 2011 study, released by the Institute for Policy Studies, revealed that at least twenty-five top United States companies paid more to their chief executives in 2010 than they paid to the federal government in taxes. (5) The study focused on the regulatory filings of the one hundred companies with the highest-paid chief executives. (6) According to the study, the companies, including Verizon, eBay, and Boeing, averaged $1.9 billion in profits and paid their chief executives an average of more than $16 million per year. (7) A variety of shelters, loopholes, and tax reduction strategies enabled the companies to evade the 35% corporate tax rate and receive an average of $304 million back in tax benefits. (8) For instance, "Verizon, which earned $11.9 billion in pretax United States profits, received a federal tax refund of $705 million. The company's chairman ... received $18.1 million in compensation." (9)

While company spokespeople disputed any noncompliance and insisted they were fully paying their fair share of taxes, the findings from the study suggest that the current United States corporate tax policy is more conducive to tax avoidance than innovation. (l0) A representative for Verizon claimed that the $18.1 million compensation was only a target that will be paid in full contingent on the rise of the company's stock and when his bonus is fully vested in three years. (11) The representative also said that the report is misleading because it fails to mention the billions of dollars in deferred taxes that Verizon will pay over time. (12) A Boeing spokesperson explained that the reason for the decline in the company's taxes in recent years is due to the huge investments it has made in U.S. Manufacturing--it has added five thousand U.S. manufacturing jobs that were incentivized by tax benefits. (13) The representative further stated that Boeing "paid hundreds of millions in cash taxes and incurred an additional $1 billion in deferred taxes that it will pay at some date in the future." (14) While it is not clear which specific accounting strategies each of these companies utilized to their advantage, it is clear that the tax shelter industry has grown rapidly over the past several years. The complexity of the Internal Revenue Code (I.R.C.) is a primary impediment that hinders the ability of the federal government to develop effective responses that will curb corporate tax loopholes.

Part I of this article gives an overview of the most frequently used corporate tax strategies, including partnership pass-through principals and carried interest. Part II discusses tax avoidance techniques put to use in a high-profile transaction that demonstrate there are few challenges that lie in the way of taking advantage of loopholes. Part III explores various existing penalties for tax-avoidance strategies and analyzes the utility and potential harm each penalty imposes on the current tax system. Part IV considers different propositions that have been introduced as a response to the tax shelter industry. Lastly, Part V evaluates tax arbitrage patterns in hopes of raising awareness and enabling detection of an industry that has escalated far beyond what was intended by Congress.

1. OVERVIEW OF FREQUENTLY USED CORPORATE TAX STRATEGIES

   1. Partnership Pass-Through and Carried Interest

      There are several strategies and loopholes that companies can take advantage of to secure high wages for their top executives and reduce company taxes paid to the government. Partnership pass-through principles are one such way that private equity managers can take advantage of the lower capital gains rate and avoid paying the higher ordinary income tax rate on their compensation. (15) This principal allows two people who are setting up a private equity fund to organize it as a partnership and serve as the two managing general partners. (16) General partners are compensated in two ways. For their investment decisions, they receive 2% of the assets as compensation for the services (which is subject to ordinary income rates). (17) They also receive 20% of the fund's profits, the "carried-interest," that is taxable at the lower capital gains rate. (18) "[C]arried interest is a share of a partnership's profits that is taxed as ... capital gain" instead of ordinary income. (19) Because "[t]he top rate on gains held longer than a year is 15%," the "tax on carried interest is usually less than half" of the tax on ordinary income, which can be taxed at up to 35%. (20) Carried interest "is permissible under the current [I.R.C.] rules because the partnership itself receives the profits in the form of capital gains...." (21) Because there is not a layer of corporate taxes through the partnership pass-through principals, the profits retain their capital-gains character when they flow through to the individual partners. (22)

      Both positive and negative sides of the current tax treatment of carried interests have been presented during congressional hearings. Private equity professionals, who are in favor of the current tax rules, argue that imposing higher marginal tax rates would prohibit risk-taking with respect to funding companies in the United States, thus hampering the United States economy. (23) In contrast, those arguing for change stress the need to ensure equality and fairness. (24) Critics of the current treatment argue that carried interests are compensation to partners in exchange for their services and therefore should be taxed like employment income. (25) Other individuals in high-paying professions (e.g., lawyers) cannot take advantage of any lower capital gains rate as a result of having their income structured in the form of carried interest. (26)

   2. Profits-only Partnerships

      Taking advantage of the intricate partnership laws is another way to avoid the corporate tax rate. Partnership laws are so complex and different from tax rules governing other arrangements because there are many unique ways to form a partnership - for example, by way of two unsuspecting entrepreneurs, a complicated investment relationship, or a joint venture between multi-national companies. There are three general categories of partnerships: service partnerships, property-services partnerships, and investment partnerships. (27) In a services partnership, the partners' contributions to the partnership consist solely of services. (28) Property-services partnerships refer to the integration of one partner's contributed property with at least one other partner's services. (29) In an investment partnership, one person contributes property and another contributes only limited services. (30)

      Any type of partnership has the ability to grant its members a profits-only partnership interest. The grantee of this type of interest has no current interest in any partnership capital, but receives the future interest in the profits of the arrangement only for the services provided. (31) The character of such income that the holders of these interests recognize is determined when it flows through from the partnership level. (32) In services and property-services partnerships, it is nearly impossible to trace profits directly from the exact source to a single owner of the source because partners become co-owners of integrated partnership property and services. (33) Therefore, the partners share in the profits as provided by their agreed allocations (e.g., 60%-40%), and they both recognize the income in the character it takes at the partnership level. (34) As a result, a partner can receive capital gain treatment for its services in a relationship where property and services are so intertwined that it is impossible to pinpoint the percentage of services provided and by which partner. (35) Given the unique inability to trace income to its source in partnerships, the Internal Revenue Service (IRS) generally does not challenge the tax-free grant of a profits-only partnership interest to a service contributor. (36)

      There is some recent debate, however, that centers on the tax treatment of profits-only partnership interests that are granted in investment partnerships. In these types of partnerships, the income is substantially derived from property (assets), while only a nominal percentage is derived from services (active trading). (37) Despite the ability to trace the partnership income from its source, tax law still allows partners in investment partnerships to allocate partnership tax items in any reasonable matter. (38) Therefore, a pure service provider in an investment partnership is able to receive income at the favorable capital gains rate instead of the ordinary income rate when the income passes through at the partnership level. The broad definition of tax partnership plays a role in being able to take advantage of this loophole.

      The federal tax definition of partnerships is broader than the non-tax definition because it includes "partnerships, limited partnerships, limited liability companies, and arrangements that fail to satisfy" the definition of those entities, such as state-law tenancies in common. (39) This definition allows participants to create "partnerships that are equivalent to employment arrangements" and that "use profits-only partnership interests to obtain long-term capital gains." (40) These partnerships can be used to "convert ordinary income (taxed at up to [35%])...