The Taxation of Profit Interests and the Reverse Mancur Olsen Phenomenon

AuthorDarryll K. Jones
PositionProfessor of Law, Stetson University College of Law
Pages853-881

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THE TAXATION OF PROFIT INTERESTS
AND THE REVERSE MANCUR OLSON PHENOMENON
DARRYLL K. JONES PROLOGUE

It is impolite, one supposes, to talk about politics in mixed company. For purposes of this Article, “mixed company” refers to the thoroughly heterogeneous groups interested in any particular item of tax legislation.1


Copyright © 2008, Darryll K. Jones.

∗ Professor of Law, Stetson University College of Law. LLM (Tax), University of Florida, 1994. This Article is based on a presentation given at the Capital University School of Law’s Annual Business and Tax Annual CLE Program, November 9, 2007. It also arose from the author’s experiences as a witness during House and Senate Hearings Congressional hearings conducted in summer and fall 2007 regarding the taxation of profit-interests. Hearings on Carried Interest II Before the S. Comm. on Finance, 110th Cong. (July 31, 2007) (statement of Darryll K. Jones), available at http://finance.senate.gov/ hearings/testimony/2007test/073107testdj.pdf; Hearing on Fair and Equitable Tax Policy For America’s Working Families Before the H. Comm. on Ways and Means, 110th Cong. (Sept. 6, 2007) (statement of Darryll K. Jones), available at http://waysandmeans.house.gov/hearings.asp?formmode=view&id=6431.

1On the other hand, a legal realist might suppose that one cannot possibly separate politics, broadly defined, from anything, especially the topic of tax reform:

Many of the problems with most contemporary analysis of the federal income tax can be traced to this untenable assumption that those policies conveniently lumped together under the rubric of tax reform are something other than the expression of a particular political perspective, one that has its own agenda, favoring certain interests over others, and with its own constituency that derives considerable political satisfaction and benefits from success in the political arena. Tax reformism is political by nature precisely because any change (whether designated as reform or otherwise) to existing political institutions and extant legal structures has distinct political implications. The adoption of any significant change to the tax law constitutes a political act. Indeed, the very decision to adopt an income tax is a political decision of the highest order. Those who characterize those diverse changes to the Code that were enacted in 1986 as tax reform are implicitly adopting the false dichotomy that there are “good” changes (those designated as tax reform which pursue the public interest and somehow rise above politics) and “bad” changes (those which favor special

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Mixed company exists with any combination of democrats, republicans, special interest groups, legislators, lobbyists, judges, advocates, moralists, scholars, rich, poor, capitalists, laborers, and other persons, whether individually or collectively, and of any disparate description, quite frankly, whose economic or moral interests are in the least bit implicated by taxation. In mixed company, then, politics are never, or hardly ever to be explicitly acknowledged as the absolute trump card of any given tax statute or decision.2Violations of this implicit social rule usually result in personal offense, since mixed company necessarily implies mixed, if not diametrically opposed, viewpoints.

The preceding observation presented itself at the January 2008 Annual Meeting of the Association of American Law Schools, during which the intellectual father of the most attended to subchapter K3legislative reform

interests and are the product of politics). This untenable classification permeates contemporary analysis of the politics of tax policy.

The pretense underlying this conceptual framework ultimately denigrates the political process. It presupposes that the traditional congressional policymaking process is “corrupt” to the extent it is tainted by politicians and interest group politics, while genuine tax reform constitutes that rare triumph of reason and the pure science of tax policymaking. Such sentiments betray a utopian longing for the day when tax academics will leave the universities and think tanks and take over the reins of the Treasury Department, and perhaps the membership of the House Ways and Means and Senate Finance Committees as well. Presumably, when that happens, tax reform no longer will be a mere aberration or departure from politics as usual, as it was in 1986. Instead, rational policymaking finally would supplant politics as usual.

Sheldon Pollack, Tax Reform: The 1980’s in Perspective, 46 TAX L. REV. 489, 491 (1991)

(emphasis added). This Article concerns the effect of collective political action on the recent efforts to reform the taxation of profit interest. Throughout, I try to avoid subjective judgments regarding whether that effect is “good” or “bad.”

2Sheldon Pollack is one of the few scholars who has written extensively regarding the direct influence of politics in the tax legislative process. See id.; Sheldon Pollack, A New Dynamics of Tax Policy, 12 AM. J. TAX POL’Y 61, 62 (1995) (concluding that the instability of the tax legislative process results from a number of “long term political trends”).

3Laws relating to the taxation of partners and other owners electing to be treated as partners are contained in subchapter K of the Internal Revenue Code, comprising I.R.C. §§ 701–61.

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proposal since 1954, Professor Victor Fleischer,4noted with palpable disgust and a gloomy visage that his thoroughly sensible efforts to reform the taxation of “profit interests” appeared doomed; not just politely declined with thanks, but repudiated in the most pejorative sense, as in the same sense as Senator Hillary Rodham Clinton’s efforts to reform health care some fifteen years earlier.5In short, the problem with which Fleischer was concerned was that persons providing services to a partnership and receiving amounts indisputably and substantively representing compensation for services (a fact admitted even by the recipients) are, under current law, able to convert income from services into income from property and thereby gain access to preferential capital gains tax rates.6

Fleischer’s reform proposal essentially called for the reinstatement of long-held tax policy to correct a glaring but little publicized inequity.7Very highly paid service providers were taxed at 20% less than much lower paid service providers, for reasons having nothing to do with policy assertions made in support of capital gains taxation.8Fleischer’s idea, originally

4See Victor Fleischer, Two and Twenty: Taxing Partnership Profits in Private Equity Funds, 83 N.Y.U. L. REV. 1 (2008) (regarding the need to reform partnership tax laws so that recipients of profit interest are prevented from converting ordinary income into capital gains). See also Note, Taxing Private Equity Carried Interest Using Incentive Stock Option Analysis, 121 HARV. L. REV. 846, 846 (2008) [hereinafter Taxing Private Equity] (“Rarely

does an idea that germinates in a law review article catch the attention of Congress. Even more rarely does such an idea inspire policy statements by presidential candidates. Recently, however, an idea that originated in Professor Victor Fleischer’s forthcoming article, Two and Twenty: Taxing Partnership Profits in Private Equity Funds, has done both. The issue to which it relates is the taxation of the so-called ‘carried interest’ that private equity professionals earn from their funds’ investments.”)

5See Health Care Reform—Dead for Now, N.Y. TIMES, Sept. 24, 1993, at A24.

6See generally Howard E. Abrams, Taxation of Carried Interests, 116 TAX NOTES 183

(2007).
7Fleischer, supra note 4, at 3–7.

8The amounts earned by hedge and private equity fund managers are so large that they raise the danger that correct analysis of underlying tax issues might be skewed by envy:

Given the fact that these funds are private, no comprehensive figures on managers’ compensation are available, although a number of consultants and trade groups do publish estimates. According to Alpha magazine, the top 25 hedge fund managers earned $14 billion in 2006. Comparable annual lists are not published for private equity managers, probably because cash distributions occur less frequently than in hedge funds, and there is greater year-to-year variation. One estimate is that managers earned $45 billion over the past six years.

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hailed as necessary as a matter of fairness,9has since been effectively caricatured as yet another example of government’s anti-capitalist confiscatory fiscal policy.10With that, the idea once talked about in circles whose inhabitants used words and phrases such as “reform,” “horizontal equity” and “distributive justice” had been exiled to American tax reform’s version of Siberia, perhaps to languish for a period of “re-education,” perhaps to await a resurrection and vindication many years hence.11

Regardless, it is useful towards a better understanding of the structure and purposes of our tax code to pause and consider the path to the status quo ante with respect to the taxation of partnership profit interests. If nothing else, reconsideration of the path to the present location rehabilitates and consoles, if such is necessary, the messenger—in this case, Professor Fleischer. More importantly, though, it forces upon us the intellectual honesty that ultimately allows for a higher regard of our tax topic. Perhaps, too, intellectual honesty will eventually lead to the reform that

MARK JICKLING & DONALD J. MARPLES, CONGRESSIONAL RESEARCH SERVICE REPORT,

TAXATION OF HEDGE FUND AND PRIVATE EQUITY MANAGERS (July 5, 2007) 1, 4,

http://opencrs.cdt.org/document/RS22689. Another commentator notes that...

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