The Taxation of Compensatory Profits Interests: The Blind Men and the Elephant
The Blind Men and the Elephant
The Taxation of Compensator y Profits Interests: The Blind Men and the Elephant
Philip F. Postlewaite 0 1 2
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1 Philip F. Postlewaite, The Taxation of Compensatory Profits Interests: The Blind Men and the Elephant , 29 Nw. J. Int'l L. & Bus. 763, 2009
2 Northwestern University School of Law
Follow this and additional works at: http://scholarlycommons.law.northwestern.edu/njilb Part of the Tax Law Commons Recommended Citation
The Taxation of Compensatory
Interests: The Blind Men and the
Philip F. Postlewaite €
According to the famous poem, six blind men approach a stationary
elephant from different angles. Each places his hand on a portion of the
elephant and exclaims that the elephant is really something other than what
it is. The declarations range from a spear (a tusk) to a snake (the trunk).
The advocacy at this symposium suggesting that the current tax
treatment of compensatory profits interests is improper from the psrteasnednpteorisn2t
of tax policy is reminiscent of that story. Each of the worthy
* "The Blind Men and the Elephant," is a poem in which six blind men come upon an
elephant, touch its distinct parts, and fail to recognize that the whole is a combination of its
parts. Saxe, John Godfrey, The Blind Men and the Elephant, in THE OXFORD ILLUSTRATED
BOOK OF AMERICAN CHILDREN'S POEMS, 24 (Donald Hall ed., 1999). Of the six, one hits the
elephant's side and concludes it is a wall, the next thinks that based on its tusk it is a spear,
another the trunk is a snake, then its leg is a tree, the ear is a fan, and the tail is a rope. Id.
Of particular applicability to this symposium is the concluding stanza serving as the moral of
the poem which cautions: "So oft in theologic wars, The disputants, I ween, Rail on in utter
ignorance Of what each other mean, And prate about an Elephant Not one of them has seen."
0 Harry R. Horrow Professor of Law and Director of the Tax Program, Northwestern
University School of Law.
Another contender for the title, suggesting a failure of the presenters and the majority of
academics who have expressed themselves on the topic to see clearly what is before them,
was "The Emperor's New Clothes" by Hans Christian Anderson. Therein, particularly in
their eagerness to please, all of the Emperor's subjects are convinced that his new finery is
beyond compare. It remains for a small child (similar to the distinct minority of academics
defending the status quo) to enlighten others to the fact that their "clarity of vision" is not
what it should be. HANS CHRISTIAN ANDERSON, THE EMPEROR'S NEW CLOTHES (Virginia
Lee Illustrator, 1949).
2Adam Rosenzweig and Darryll Jones begin their assault in a similar fashion. Each has
latched on to but a portion of the overall beast, i.e., the tax treatment of the receipt of a
compensatory profits interest in a partnership, and has advanced his analyses on the basis of
focuses upon but a portion of the topic of executive compensation through
the transfer of an equity interest in a business enterprise. Exploring but
one component of the whole, i.e., the transfer of a profits interest in a
partnership, they exclaim that its essence is so overwhelmingly similar to
compensation received for the rendition of services by an employee from an
employer that its tax treatment should be identical, i.e., ordinary income
taxed at progressive rates should be accorded the entirety of the return
Services are rendered to the partnership by the recipient of the profits
interest as is the case in the employee and the employer context. The
employee renders only services and is taxed at progressive rates. In the
latter case, the entirety of the compensation for the duration of the
relationship is taxed at ordinary income rates. Accordingly, like the blind
pmreasnenwtehros toausscehretst hthaet tehleeprheacneti'pst taoifl aanpdroisfittshuisntceerretsatinorthaatcaitrriiseda rionpteer,esthte5
should similarly generate ordinary income throughout the duration of the
recipient's relationship with the enterprise because he or she is nothing
comparison with the employee/employer context instead of a comparison with the other
categories of equity compensation in a business enterprise. Darryll K. Jones, Sophistry,
SituationalEthics, and the Taxation of the CarriedInterest, 29 Nw. J. INT'L L. & Bus. 675
(2009); Adam H. Rosenzweig, Not All CarriedInterestsAre CreatedEqual,29 Nw. J. INT'L
L. & Bus. 713 (2009). The landscape for the transfer of compensatory equity interests in a
traditional business enterprise is broad and includes stock and restricted stock in the
corporate context and a capital interest, a restricted capital interest, and a profits interest in
the partnership context. In such a setting, the taxation of a compensatory profits interest is
3 Surprisingly, they continue to do so even after having read my prior publication on the
topic in which I summarized the entirety of the tax treatment of compensatory equity
transfers and illustrated the consistency of the taxation of profits interests in a partnership
with that accorded the treatment of compensatory transfers of stock in a corporation and
compensatory transfers of capital interests in a partnership. See generally Philip F.
Postlewaite, Fifteen and Thirty Five: Class Warfare in Subchapter K, 28 VA. TAX REV.
(forthcoming Spring 2009). Obviously, my powers of persuasion leave something to be
4 Professor Rosenzweig innovatively offers a somewhat different approach
generates short-term, rather than long-term, capital gain. Rosenzweig, supra note 2. But for
its ability to absorb capital loss, which given the economic meltdown is more valuable than
is normally the case, his proposal produces similar results, because short-term capital gain is
not entitled to preferential tax treatment.
5 The substitution by the presenters of the term "carried interest," descriptive of the
partnership interest received by the general partner of a private equity or hedge fund, does
not change the essence of the proprietary interest. In spite of the populist efforts to engage in
class warfare which is made easier if the target is more narrow: a "carried interest" is a
"profits interest." One cannot alter the tax treatment of one without altering the other.
Accordingly, any proposed change must apply throughout the world of commercial
enterprises and must be equally applicable to the small commercial partnership as well as the
gigantic private equity firm.
more than a service provider.
The position increasingly held by academics is that the current tax
Apparently, the small but determined group which defbeendsobtvhieousstattuos qaullo.67
treatment of such receipts is improper and should
not only fails to appreciate the clarity of the situation,8 but their analysis is
derisively dismissed as sophistry and their motives impugned for acting as
tools of the establishment.
As the lowly representative of the Gang of Three, and the only one
apparently not smart enough to be paid for his advocacy,' 0 notwithstanding
the intensity and inventiveness of the presenters' advocacy, I remain
unconvinced. My support for the status quo appears elsewhere and is most
detailed and recommended for those with further interest." Herein, I will
limit my response to the larger themes of equity compensation in the
business enterprise context, with cross references to my prior work for
those who wish to pursue the matter further. The overriding criticism by
the presenters of the status quo for recipients of compensatory profits
interests is the lack of parity among similarly-situated recipients. Both
make their case for changing the current tax treatment of carried interests
because of this defect. The virtues of horizontal equity are extolled by the
presenters. 12 However, the difficulty in the application of the tax policy
6 Jones, supra note 2, at 683-84; Rosenzweig supra note 2, at 721-24. See Laura
Cunningham, Taxing PartnershipInterests Exchanged for Services, 47 TAX. L. REv. 247
(1991); Victor Fleischer, Two and Twenty: Taxing PartnershipProfits in Private Equity
Funds, 83 N.Y.U. L. REv. 1 (2008); Mark P. Gergen, Reforming Subchapter K:
Compensating Service Partners, 48 TAX. L. REv. 69 (1991); Leo L. Schmolka, Taxing
PartnershipInterests Exchangedfor Services: Let Diamond/Campbell Quietly Die, 48 TAX
L. REv. 287 (1991).
7 See Howard E. Abrams, The Taxation ofCarriedInterests, 116 TAX NOTEs 183 (2007);
Postlewaite, supra note 3; David A. Weisbach, The Taxation of CarriedInterests in Private
Equity, 94 VA. L. REv. 715 (2008) [hereafter Gang ofThree].
8 Jones states that "[tihe overarching assertion made in this Article-that arguments in
support of the status quo cannot be explained by logic, reason, or deduction-is intended to
allow readers to draw the conclusion implicit in the Article's title." Jones, supra note 2, at
9 "Instead, I seek only to insist that proponents are not entirely disinterested in the
outcome." Jones, supra note 2, at 678 n.9. "With due respect to the proponent, this Article
categorically labels that path sophistry .... Id. at 699.
1oSee Abrams, supra note 7; Weisbach, supra note 7, at 715.
11See Postlewaite, supra note 3.
12Jones elevates horizontal equity as a governing principle of taxation: "Horizontal
equity-basic fairness-is the ethic that is so obviously violated by the taxation of the
carried interest vis-A-vis the taxation of other yields to services." Jones, supra note 2, at 710.
Jones also states that "horizontal equity has a preeminent place in tax jurisprudence." Id. at
684. Rosenzweig asserts that "proponents of changing the taxation of carried interest claim
that this disparate treatment violates the norm of horizontal equity, which provides that
similarly situated taxpayers should bear similar tax burdens." Rosenzweig, supra note 2, at
guideline emphasizing horizontal equity is in ensuring that one is
comparing the relevant parties, i.e., apples to apples, in making the
assessment. Many advance the employee as the center point for comparison
because the return on their services is taxed at progressive rates. 13 I instead
offer the corporate or partnership executive as the appropriate focal point,
whose return from his expenditure and investment of services under the
current tax law is frequently entitled to preferential treatment.
The presenters collectively ignore a number of critical factors in their
analysis, each of which will be discussed further below. Most importantly,
they focus exclusively upon the recipient of a profits interest and the tax
consequences therefrom without comparing those consequences with the
other categories of recipients of compensatory equity interests.
Furthermore, they ignore the fact that a profits interest in a partnership
without withdrawal becomes a capital interest and the failure to take a
salary in lieu of the equity interest results in an investment of that amount in
the enterprise. Finally, they minimize the dictates of § 702(b) and the
congressionally mandated equality of treatment of all members of the
partnership regardless of whether their contribution to the enterprise is of
property or services.
BOOTSTRAPPING WITH THE RENDITION OF SERVICES ROPE
Instead of focusing on the whole (the tax treatment of all
compensatory equity recipients), the presenters address but a small part
(profits interests) of the field of equity compensation. Having discovered a
rope with which to elevate their analysis to the center of attention, they
narrow their focus accordingly. Advocates, as the sine qua non of their
assault, rely on the fact that the return from the rendition of services is
treated as ordinary income taxed at progressive rates. 14
Employees pay taxes at regular rates. Accordingly, private equity
managers should be treated similarly in order to foster horizontal equity.15
Notwithstanding the difficulty of determining who is similarly situated with
whom, the presenters assert that horizontal equity dictates that
similarlysituated taxpayers be treated similarly. 16 From this base they elevate their
724. The difficulty again is their assumption that the similarly-situated party is a non-equity
service provider rather than other recipients of compensatory equity interests in a business
13Jones, supranote 2, at 682-83.
15 Id. "Thus, that a service provider may very well be referred to as 'partner' under state
and even federal law is of no logical consequence to the determination of whether the service
provider ought to be taxed more favorably than a service provider who is not so labeled by
any definition." Id. at 682. As discussed below, the obstacle to this result imposed by the
enactment of § 702(b) is apparently of little concern.
16 Id. at 698 (suggesting that those who support the status quo acknowledge the deviation
argument, one advocating taxing income from a profits interest as ordinary
produces thwehislaemethreesoutlht.e'r8 adopts a less pure approach that functionally
According to them, the return from the rendition of services in some
manner must be taxed at the progressive rates.' 9 Thus, the profits interest
(aka carried interest) recipient should be taxed on the entirety of his or her
return at progressive rates. 20 Yet neither advocate subjects other equity
recipients to the same treatment. 21 There is no such advocacy for the
extension of such treatment to equity recipients of the four other categories
of executive equity compensation. If the presenters' views were adopted,
the recipient of a profits interest would be discriminated against by the
federal tax laws because they would receive worse tax treatment than their
counterparts. In fact, they would be the only category of recipients of
compensatory equity interests in a business enterp2rise subjected to tax at
ordinary income rates on the entirety of their return.
There are five categories
of compensatory equity recipients in the
from horizontal equity: "The most telling aspect of the various arguments offered in support
of the status quo is that they all implicitly admit that taxing fund managers for their services
in a manner preferential to the compensation received by other service providers is contrary
to horizontal equity."); Rosenzweig, supra note 2, at 724. My position in fact is to the
contrary. Postlewaite, supra note 3, at 1-66. The status quo for the taxation of a profits
interest is consistent with the treatment of other compensatory recipients of equity interests
in a business enterprise.
17Jones, supranote 2, at 684-98.
18Rosenzweig, supra note 2, at 755-62 (utilizing a short-term capital gain approach
which would not be entitled to preferential treatment).
19Rosenzweig, supra note 2, at 722. The presenter states that "[iun general, for tax
purposes, when a service provider receives property in exchange for services, the value of
the property is treated as salary, or ordinary income, on the date of issuance." Id. Later, the
presenter attempts to utilize holding period doctrines to produce short-term capital gain for
private equity firms. Id. at 734-35. While such gain does not qualify for preferential rates,
it has some value superior to that of ordinary income. Under the general rules, only $3,000
of capital loss can offset ordinary income. I.R.C. § 1211 (2009). However, short-term
capital gain may offset an equivalent amount of capital loss, which may prove significant
given the economic meltdown of 2008 and 2009 and the tremendous amount of market loss
sustained by investors. Even his fellow presenter is critical of such an approach: "In other
words, the short term holding period solution actually supports the status quo, even as the
proponent admits that capital gain taxation is incorrect." Jones, supra note 2, at 709.
20 According to Rosenzweig, "managers of private equity funds were effectively being
compensated for their services while receiving income in the form of capital gain for tax
purposes." Rosenzweig, supra note 2, at 723-24.
21Jones, supra note 2, at 696 (failing to acknowledge the extension of preferential
treatment to other recipients of compensatory equity interests: "Every entrepreneur is a
risktaker, but only entrepreneurial investors of previously taxed income are taxed at lower
rates .... "). As I have documented previously, this is not true for the four other categories
of compensatory equity recipients.
22 See generally Postlewaite, supra note 3, at 16-29.
traditional commercial enterprises which utilize either the corporate or
partnership vehicle for the conduct of business activities. In the corporate
context, a corporate executive can receive a compensation package of salary
and/or stock. If stock is received, ownership may vest upon receipt or
instead upon the completion of service upon which the grant is
conditioned.24 Similarly, in the partnership context, a service provider can
receive a compensation package of a guaranteed payment (salary) and/or a
capital interest in the enterprise and/or a profits interest.25 If an equity
interest is received, ownership may vest upon receipt or instead upon the
completion of service upon which the grant is conditioned.
Under existing law, a service provider in receipt of corporate stock is
taxed at the progressive rates on the value of the stock upon receipt or its
vesting if restricted. That amount becomes his or her basis for the stock.26
Upon the disposition of the stock, even though the executive provided
services to the enterprise over the entirety of the ownership period, the gain
on the disposition of the stock will be taxed as long-term capital gain,
which receives preferential treatment.
In the partnership context, a service provider in receipt of a capital
interest is taxed at progressive rates on the liquidation value of the stock
upon receipt or its vesting if restricted.27 That amount becomes his or her
basis for the partnership interest. Upon the disposition of the capital
interest, even though the equity partner provided services to the enterprise
over the entirety of the ownership period, while not as favorable as that
accorded the corporate context, the gain on its disposition will also be taxed
as long-term capital gain if the underlying assets are similarly classified.
Thus, under current law, the service provider in receipt of an equity
interest in a corporation or a partnership has the overall gain from the
rendition of services over the life of the enterprise taxed both at progressive
rates and at preferential rates. Congress has decided to bifurcate the service
provider's return from the rendition of services by treating the value of the
equity interest upon receipt or vesting as ordinary2i8ncome and the remaining
gain upon disposition as long-term capital gain. Some of this treatment
derives from the re-investment of funds in the enterprise which the service
way the law has attempted to address the issue was not by deconstructing such returns into
constituent parts, but by imposing a 'holding period' requirement."). As evidenced above,
the Code with respect to blended labor/investment returns has done the opposite by
providing generally for ordinary income upon receipt and capital gain upon disposition of
provider relinquished by taking an equity interest rather than a salary.2 9
Accordingly, the adoption of the presenters' proposals would
discriminate against the recipient of a profits or a carried interest. Contrary
to their rhetoric about the privileged treatment available to such holders
under the current law, the adoption of their proposals would leave the
recipient of a compensatory profits interest in a partnership as the only
category of service providers to business enterprises compensated with
equity interests liable for tax at progressive rates on the entirety of their
In addition, those advocating reform in this area are forced to address
the ramifications of such a change in the international arena. 30 The possible
"unintended consequences" of such a modification range from the
relocation of industries offshore, attempted manipulation of the
international taxing provisions, and the possible need for collaboration by
the United States with its European trading partners. An additional benefit
of retaining the status quo is that none of these issues needs to be addressed.
A maxim of tax policy is that an old tax is a good tax. Everyone has
adjusted to the prevailing regime and the issues created by a prospective
change are avoided.
THE IMAGINARY WALL BETWEEN A PROFITS INTEREST AND A
Another difficulty with the presenters' advocacy is their belief that a
wall of meaningful distinction separates a profits interest in a partnership
from a capital interest therein.3 1 Accordingly, because they view each as
different from the other, their proposals need not acknowledge the
symbiotic relationship between the two.
The difficulty is that such is not the case under the current taxation
regime of Subchapter K of the Code.32 Even the presenters acknowledge
that most recipients of a carried interest acquire a capital interest as well in
order to have "skin in the game."3 3 The focal point of their advocacy is the
disproportionate amounts of each, e.g., a three percent capital interest and a
twenty percent profits interest.3 4 However, as time marches on,
29 For intense criticism of my position, see Jones, supra note 2, at 699 describing the
argument as "sophistry."
30See Jones, supranote 2, at 676; Rosenzweig, supra note 2, at 747-55.
31Pink Floyd's refrain from The Wall that "we don't need no education" appears
descriptive of their position. PINK FLOYD, Another Brick in the Wall Part 2, on THE WALL
(Capitol 1979). Both have read my prior work, yet seem resistant to accepting the insights
32See generally Postlewaite, supranote 5, at 44-45.
33Jones, supra note 2, at 704; Rosenzweig, supra note 2,at 718.
34Jones, supra note 2, at 705-09; Rosenzweig, supra note 2, at 718.
unwithdrawn profits from year one increase the service provider's capital
account in year two. Furthermore, those amounts are available for
utilization in the business operations of the enterprise.
In fact, but for the year of receipt, the recipient of a compensatory
capital interest is treated in an identical fashion to the recipient of a
compensatory profits interest. For example, the service provider in receipt
of a compensatory twenty percent capital interest and his counterpart in
receipt of a twenty percent profits interest will be taxed on the same amount
and at the same character on everything produced by the partnership except
the initial grant. 35 Thus, the proffered chasm in treatment between the two
categories of compensatory equity recipients is de minimis at best.
FANNING AT THE SIGNIFICANCE OF CHARACTERIZATION AT
THE LEVEL OF THE PARTNERSHIP
The presenters assume that all profits interests in a partnership
generate preferentially taxed returns.36 However, due to the governance of
§ 702(b), enterprise receipts are characterized at the partnership level.37
Thus, if the nature of the income-producing activities of the partnership or
the character of its assets is such, profits interests can generate exclusively
ordinary income taxed at progressive rates.38 Therefore, the current law
35 For a documentation of these results, see generally Postlewaite, supra note 3, at 24-26.
36 Jones, supra note 2, at 695 (asserting that all profits interests generate preferential tax
treatment: "Implicit in proponents' arguments is that the extent to which a taxpayer risks
transferring her services for no compensation-as is the case when a taxpayer agrees to be
compensated only if the venture proves successful-she is entitled to a reward in the form of
lower tax rates."). As documented elsewhere, such is not the case. As every profits interest
holder in a law firm knows, their share of the firm's income is not taxed preferentially. See
generallyPostlewaite, supranote 3, at 52-56.
37 The presenters miss the focal point in the partnership context for the determination of
capital gain entitlement. They erroneously attempt to impose the raison d'etre of capital
gains, e.g., the factors of lock in, bunching, investment motivation, etc., on the recipient of
the equity interest rather than on the enterprise in which he received the interest. Congress
instead through the enactment of § 702(b) mandated that it is determined at the partnership
level vis-A-vis its relationship to the assets which it holds. Rosenzweig states that
"proponents of reform also contend that such taxation violates the underlying policies
supporting the distinction between ordinary income and capital gains." Rosenzweig, supra
note 2, at 725. Later, he reiterates this distinction: "Similarly, the concern over carried
interest is that the GP is effectively being compensated for services, which do not suffer
from bunching and lock-in, but is receiving the benefit of long-term capital gains preferential
rates." Id. at 741. See also Jones, supranote 2,at 702-03 (same).
38 Initially, one of the presenters appears to embrace this distinction as governing the
appropriate tax treatment. Rosenzweig, supranote 2, at 734. "Accordingly, the focus in the
carried interest debate should not be on the method of compensating the manager of a private
investment fund, but rather on the types of income being generated and allocated by the fund
to the manager." Id. In the next section of his analysis, he strays from this approach and
centers his focus on the essence of the equity interest rather than the underlying assets:
The Blind Men and the Elephant
THE FOREST POSSESSES MORE THAN ONE TYPE OF TREE
The presenters appear to assume that there is but one type of tree
deriving improper tax treatment in the forest. Accordingly, they are not on
ready alert when they survey the landscape of Subchapter K for needed
If one elevates horizontal equity to the be all and end all and
commands that the rendition of services begets ordinary income taxed at
progressive rates, then he or she must similarly insist that the contribution
of capital generates capital gain. The presenters evidence little or no
concern with the impact of § 702(b) on a contributor of capital, yet
complain about its distortion in the service provider context.
However, Subchapter K, with its focus on the entity rather than its
members, consistently undercuts such maxims by insisting upon consistent
treatment for all partners. 4 1 As the presenters have properly noted, § 702(b)
may generate ordinary income or long-term capital gain to service providers
depending upon the nature of the activities and the assets of the enterprise. 42
"[T]he line-drawing debate which has received the bulk of attention in the recent carried
interest literature is whether carried interest should be treated as capital gain or ordinary
income." Id at 734.
39Rosenzweig, supra note 2, at 715 (recognizing that profits interests do not always
generate preferential treatment: "Most notably, the tax treatment of the equivalent of carried
interest in most hedge funds raises little of the same preferential rate concerns that plague
carried interests in private equity funds, precisely because even under currentlaw the profits
paid to hedge fund managers are generally not entitled to preferential rates.")(emphasis in
original). Even recognizing that distinctions exist between hedge funds and private equity
firms due to the underlying activities of the enterprises, he nevertheless forges ahead to
generate equivalent results in both settings while acknowledging that their activities are
40 See Rosenzweig, supra note 2, at 715, where he asks: "The question that follows is: if
the concern is over preferential rates for carried interest, why is there such a problem with
the taxation of carried interest for private equity but not for other private funds?" While he
articulates that the distinction is due to the types of assets held and the activities performed
by private equity firms compared to hedge funds, he appears unwilling to accept that this is a
meaningful distinction upon which sound tax policy principles can be based.
41I.R.C. § 702(b) (2009).
42 Rosenzweig and Jones acknowledge that income characterization occurs at the
partnership level. Jones, supra note 2, at 700; Rosenzweig, supra note 2, at 755.
Accordingly, a short-term partner would be entitled to preferential tax treatment on his share
of the partnership's long-term capital gain notwithstanding his abbreviated holding period.
After having documented the distortion it can produce, Jones suggests that the common law
of taxation can override the congressional mandate where the transaction is sufficiently
By way of example, a service provider equity owner in a law firm
typically derives ordinary income while a similar holder in a private equity
fund derives capital gain.43 Alternatively, a capital contributor to a
restaurant derives ordinary income while a similar holder in a private equity
fund derives capital gain. Parity among service providers and capital
contributors does not exist in Subchapter K.
Importantly, has a word emanated from the forceful presenters about
this departure from the principles of horizontal equity? Some contributors
of capital in the partnership context will not derive preferential capital
gains.44 Yet, this distortion apparently is of such minimal concern that it
escapes their notice and commentary. Given the presenters' emphasis on
horizontal equity, one would expect similar outrage at this imperfection in
the Code and legislative proposals to follow.
Another blind spot in the presenters' analysis is the issue of value.4 5
Again, they assume that all valuation issues must be determined with the
same criteria and assert that the focus in such a determination be on the
economic reality of the setting. Because the receipt of a profits interest has
Simply put, proponents argue that partnership level characterization of income is
inviolate. That is, the benefit of the rule is so great that it ought to be followed
even in the rare circumstances where it causes a distortion of the partner's true
circumstances.... Unfortunately, the argument is belied by a very conspicuous
provision in Subchapter K.
Jones, supra note 2, at 700. In his effort to disprove the applicability of § 702(b) in all cases,
he references the "conspicuous provision" of § 724, which characterizes gain or loss based
upon the prior activities of a partner, rather than the nature of the asset to the partnership. Id.
at 700. However, notwithstanding his suggestion that this undercuts the universality of
§ 702(b), in fact it does the opposite. The re-characterization affects all partners and not
merely the contributor. Furthermore, the existence of the supposed exception proves too
much. Congress has the power to act if it decides that such is needed. It has not deemed
other areas worthy of modification. Also, the presenter does not suggest an extension of
such a "look through" approach to those who contribute capital to a partnership but, due to
§ 702(b), derive ordinary income.
43 This blind spot in the presenters' analysis is evidenced by their tenacious, yet
erroneous, assumption that all profits interests are taxed preferentially. As documented
above, it is the nature of the activities of the enterprise which will dictate the character of the
income to the service provider. Thus, a profits interest in a law firm, which subjects the
holder to dramatic economic risk as evidenced by events of the first quarter of 2009 in the
legal community, invariably generates ordinary income.
44 See generally Postlewaite, supra note 3, at 52-56.
45 Jones asserts that "the grant is capable of quantification in monetary terms ....
Jones, supra note 2, at 687. Jones also asserts that "[t]o say that the right has no value is also
to stipulate that the services used to acquire that right have no value. This is incorrect as a
matter of rationality." Id. at 703. See also Rosenzweig, supra note 2, at 722 ("the carried
interest must have some economic value to the GP since the GP accepted it in the first place
and could earn substantial amounts in the future.").
economic value, the tax treatment of a profits interest as having no value
cannot be justified. Their error is the failure to distinguish between
economic value and liquidation value and to integ4r6ate the latter concept into
the conduit nature of the taxation of partnerships.
The standard for taxing the receipt of an equity interest (capital or
profits) in a partnership is liquidation value. This is necessary because all
subsequent derivation of profit will be taxed to the holder annually. Given
that mechanism and design, one need only capture the liquidation value
upon receipt of the partnership interest or at its time of vesting.47 If a
greater amount is included, distortion of results will arise because the
recipient's share of subsequently derived profit, upon which he would have
been taxed upon receipt, would be taxed again.4 8
Current liquidation value upon receipt is the very factor that
differentiates a capital interest (current liquidation value) from a profits
interest (no current liquidation value) with regard to the amount to be
included in income upon receipt. 49 All future accretions from the
ownership of the interest will be taken into account annually as they arise
and will be identical for both types of recipients.
DRIVING A SPEAR INTO THE HEART OF THE ABUSE
Identifying the targeted category of equity recipient and eager to slay
the opposition, the presenters launch their weapons of mass
deconstruction. 50 One of the presenters contents himself with the assertion
46 See generally Postlewaite, supranote 3, at 44-48.
47 While I do suggest that the overall treatment of the receipt, retention, and disposition
of compensatory equity interests is logical and arose by congressional and administrative
intent, others suggest that "capital gains taxation of carried interest arose by mistake rather
than by intelligent design." Jones, supra note 2, at 684.
48 Given the interrelationship of the conduit aspects of Subchapter K, the additional
income will be offset upon the recipient's exit from the partnership by an equivalent amount
of loss. Nevertheless, timing and characterization imperfections have prevented the adoption
of an economic, rather than liquidation, standard.
49 See also Jones, supra note 2, at 687: "Even though the grant is capable of
quantification in monetary terms, it is not income as that term is popularly understood." The
assertion is somewhat contradictory because if it were susceptible of proper valuation, then
theoretically it should be subject to tax as is the compensatory receipt of corporate stock or a
capital interest in a partnership. Neither presenter addresses the double taxation issue arising
from the use of economic, rather than liquidation, valuation, first upon receipt and again on
subsequent earnings. Furthermore, the tax policy principle of realization, when combined
with conduit taxation, errs on the side of accuracy. The current tax treatment of an equity
recipient of a profits interest is no different than that for the equity recipient of a capital
interest, the value of which in the recipient's hands is likely greater than its liquidation value.
Thus, the "imperfection" in utilizing liquidation value is not unique to profits interests.
50One of the presenters asserts that the tax law avoids deconstructing in this area, noting
that "[h]istorically, one way the law has attempted to address the issue was not by
deconstructing such returns into constituent parts, but instead by imposing a 'holding period'
that the rendition of services as a recipient of a profits interest in a
partnership by definition mandates that the return thereon be taxed at
progressive rates.5 1 Services are services and whatever distinctions can be
advanced by proponents for such treatment are inadequate and/or
irrelevant. 52 However, by doing so, he ignores the differing treatment
accorded the other four categories of recipients of equity compensation in a
business enterprise. The fact that his proposal will actually discriminate
against a category of equity recipient is of no consequence to his advocacy.
The other presenter, in an effort to "produce the right result" without
having to dismantle Subchapter K, suggests that the holding period concept
should be utilized to prevent preferential tax treatment.53 Accordingly, he
advocates the aulication of the straddle rules of § 1092 to the recipient of a
profits interest. Because the profits interest is unaccompanied by a loss
interest in the partnership, he asserts that this minimizes/eliminates the risk
of loss.15 Among the other consequences of a straddle, the holding period
for the partnership interest tolls. As a consequence, the presenter maintains
tahsasthtohret-treercmipiceanpti'stalshgaarien toafxtehde apt aprrtongerresshsiipv'es rgaatienss.5 6would be characterized
Apparently, this presenter assumes that the interest holder is immune
from all losses incurred from the holdings of the enterprise. However, in
many cases, a profits interest is accompanied by an equivalent interest in
loss. 57 While not addressed by the presenter, it would appear that such risk
requirement." Rosenzweig, supra note 2, at 713. However, as I have surveyed the status
quo, the tax law deconstructs the receipt as generating ordinary income to the extent of its
value (liquidation in the partnership context) upon receipt and capital gain upon its
disposition. See generallyPostlewaite, supra note 3, at 12-29.
51Jones states: "Thus, that a service provider may very well be referred to as 'partner'
under state and even federal law is of no logical consequence to the determination of
whether the service provider ought to be taxed more favorably than a service provider who is
not so labeled by any definition." Jones, supra note 2, at 682.
52 "In short, sometimes extraordinarily well-paid fund managers receive compensation
taxed at capital gains rates. All other, usually very much lower-compensated, service
providers are taxed at ordinary rates." Jones, supra note 2, at 675. As I have documented
herein and in my prior work, this is simply not the case. See Postlewaite, supranote 3, at
53See Rosenzweig, supra note 2, at 755-62.
56 Id. at 755. "One major benefit of the holding period proposal to the taxation of carried
interest is that it is arguably not only the proper policy answer, but that it also would be
much simpler to integrate into current law." Id.
57To the extent they do not possess an interest in losses, other arguments as to whether a
genuine partnership exists or whether the holder is an actual partner may apply. Jones
suggests that: "Subchapter K has long since addressed the mischief that results when
partners receive gain or profit while nominally occupying the status of partner but
substantively performing as an employee or in some capacity other than a partner." Jones,
would immunize the recipient from the application of his proposed
treatment. In light of the assumed profitability of private equity funds, a
mere extension of the recipient's interest in loss would be a meaningless
gesture economically yet an effective means of circumvention, rendering
the proposal meaningless in its application.
However, in contrast to true straddles, it would appear that the analogy
falls short for a number of reasons. Even if the approach applied in the first
year to the recipient's share of the partnership's gains, unless withdrawn,
the funds blossom into a capital interest thereby creating a potential risk of
loss against which the second year's profits interest may no longer be
Additionally, under § 1092, the positions must offset. According to
the legislative history, the properties must vary inversely in value. 58 The
offsetting positions must bear a one to one ratio. To suggest that positions
are "offsetting" when gain is possible but loss is not appears to constitute a
broader application of the Code provision than intended by Congress.
While his innovative effort at reverse engineering to produce equivalent
treatment between hedge and private equity funds is striking, logic would
dictate the extension of such a doctrine to all profits interests. It is
uncertain whether the presenter would support an extension to the recipients
of all profits interests.
THE TEMPTATION OF THE SERPENT
Like the Biblical temptation when the snake offered Eve the apple, one
of the presenters cannot resist the opportunity to impugn the motives and
the analysis of those with whom he disagrees. While he is in the majority
of those academics to date who have commented upon the issue, he
concludes that the matter is of such importance that the small minority
suggesting to the contrary are sophists and opportunists engaged in
situational ethics. 59 Such are the consequences of populist uprisings.
Instead of relying upon reasoned discourse, they reach for pitchforks and
torches in their eagerness to paint their opponents as evil rather than merely
supra note 2, at 702. Rosenzweig also describes the factual particulars of the relationship of
the fund managers with the enterprise which arguably suggest an employment rather than
equity relationship. Rosenzweig, supra note 2, at 718-20. Whether this approach to the
presenters' problem would provide a preferable solution in the private equity context does
not minimize my advocacy for the statusquo. If the recipient is not a partner, § 702(b) is not
applicable to the return from the enterprise. However, that is a topic for another paper.
58 S. REP. No. 97-144, at 150 (1981) (stating "[g]enerally, values vary inversely if the
value of one position decreases when the value of the other position increases.").
59 Jones states that "[t]he fundamental thread that should answer tax questions without
the need for convoluted statutory explanation becomes frayed each time sophistry and
situational ethics are allowed to trump fundamental principles." Jones, supra note 2, at 68 1.
Another temptation which undercuts the analysis of the presenters is
the Midas assumption. They assume that everything touched by the world
of private equity turns to gold. Because the assault on the tax treatment of
profits interests coincided with an economic period of prosperity, the
assumption is that such activities are always profitable and thus risk free.60
One of the presenters attempts to minimize the presence of risk by
suggesting that the management fee (the two) which accompanies the
profits interest (the twenty) in the standard two and twenty compensation
package for private equity fund managers eliminates risk.6 1 Apparently, in
his mind, if the profits interest does not generate any revenue, the recipient
does not experience a loss. He maintains that the negotiation of a salary
and an equity interest carries no risk because the amount of the salary
component equals the full value of his services. Accordingly, the economic
results from the profits interests are only upside and risk free.62
However, if that is the case, then it applies to virtually every recipient
of a compensatory equity interest in a corporation or a partnership since
virtually all of them receive a salary along with the corporate stock or a
guaranteed payment with their capital interest. The presenter fails to take
into account that this is a characteristic common to virtually all
compensatory receipts of equity. If true, all must be subjected to ordinary
income on the entirety of their return, which is not currently the case.
As is evidenced by the presenters' offerings, change is in the air. The
status quo is unacceptable, even though it has continued intact for over
sixty years. They suggest that "there is nothing as powerful as an idea
whose time has come," and in their mind the time is now. The difficulty is
that the populist uprising over the taxation of profits interests was driven by
a bubble in the economy, when the Midas touch appeared to be
60 Rosenzweig provides an example, in which gargantuan profits are assumed: "[T]he LP
received a return of slightly higher than forty percent on the initial capital investment ....
The GP, on the other hand, earned a staggering return of one thousand percent on its invested
capital." Rosenzweig, supra note 2, at 720. Jones argues that "[t]he 'entrepreneurial risk'
argument is deficient for several reasons, including the initial fact that the fixed portion of
fund manager compensation eliminates any risk of loss." Jones, supra note 2, at 682. Even
government statistics during the era of prosperity showed that one-third of all private equity
fumds did not yield a return on their profits interests. See Postlewaite, supra note 3, at 35.
Certainly, after the economic meltdown, it should be clear that loss is a possibility. Risk
permeates these interests.
61See Jones, supra note 2, at 682.
62 Assuming arm's length behavior, this is most unlikely. If the managerial talents of a
person were worth $400,000, one would not expect another to pay $400,000 and twenty
percent of the profits for his services. Instead, the management fee would be lowered, e.g.,
$250,000 plus the twenty percent profits interest. In such a case, if no profits are generated,
the service provider will certainly conclude that he bore and sustained a risk of loss.
omnipresent. Tax rates were low, the market hit 14,000, unemployment
was low, and private equity firms and hedge funds (most legitimate but
some Madoff-like) were profiting enormously.
However, those days are gone, and with them, the momentum fueled
by populism and class warfare is in decline. Ironically enough, Congress
may need to consider greater, not lesser, incentives to lure such firms into
the massive challenge of revitalizing our economy.63
At a minimum, notwithstanding the best efforts of the presenters, I
remain convinced that the status quo on the taxation of compensatory
profits interests (which subsumes carried interests) is as good as we can do
with the overall fabric in which we operate. As opposed to the myopic
view of the presenters, once one focuses on the elephant as a whole, rather
than only a portion of it, the system appears to be well designed. At a
minimum, the treatment of a recipient of a compensatory profits interest in
a partnership is consistent with the treatment of the other categories of
recipients of compensatory equity interests in a business enterprise.
The true culprit which causes the heated debate of fairness is not
private equity firms and their compensatory packages. Instead, it is the
presence of preferential treatment for a class of income, long-term capital
gains, which is not all inclusive. Whether such distinctions should exist is a
matter for another debate. However, assuming its continuation, the status
quo and the conversion and deferral potential for the recipient of a profits
interest is consistent with the overall framework for executive equity
63 Even one of the presenters acknowledges that such a change could be possible. Jones
states that "[i]f it were proven that fund managers are so risk averse that the market cannot
account for that aversion, preferential tax treatment of those scarce labor suppliers would be
justified. That case has not and likely cannot be made." Jones, supranote 2, at 682.