Legal Studies Research Paper Series

Working Paper Number 06-27 March 2006

Revised May 4, 2007

TWO AND TWENTY:

TAXING PARTNERSHIP PROFITS IN PRIVATE EQUITY FUNDS

FORTHCOMING, NYU LAW REVIEW (2008)

Victor Fleischer

Associate Professor University of Colorado Law School

Associate Professor

University of Illinois College of Law (effective June 2007)

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TWO AND TWENTY: TAXING PARTNERSHIP PROFITS

IN PRIVATE EQUITY FUNDS

Victor Fleischer*

Private equity fund managers take a share of the profits of the

partnership as the equity portion of their compensation. The tax rules for compensating service partners create a planning opportunity for managers who receive the industry-standard “two and twenty” (a two percent management fee and twenty percent profits interest). By tak-ing a portion of their pay in the form of partnership profits, fund man-agers defer income derived from their labor efforts and convert it from ordinary income into long-term capital gain. This quirk in the tax law allows some of the richest workers in the country to pay tax on their labor income at a low rate. Changes in the investment world – the growth of private equity funds, the adoption of portable alpha strate-gies by institutional investors, and aggressive tax planning – suggest that reconsideration of the partnership profits puzzle is overdue. In this Article, I offer a menu of reform alternatives, including a novel cost-of-capital approach that would strike an appropriate balance be-tween treating returns on human capital as ordinary income and re-warding entrepreneurial activity with a tax subsidy.

* Associate Professor, University of Colorado Law School; Associate Professor, University of Illinois College of Law (effective June 2007). I am indebted to Alan Auerbach, Steve Bank, Deborah DeMott, Wayne Gazur, Bill Klein, Henry Ordower, Miranda Perry Fleischer, Alex Raskolnikov, Ted Seto, Dan Shaviro, Kirk Stark, Larry Zelenak, and Eric Zolt for their helpful comments and suggestions. I thank the participants at the 2006 Junior Tax Scholars Confer-ence, the Tax Section of the AALS 2006 Annual Meeting, the Agency & Partnership Section of the AALS 2007 Annual Meeting, the UCLA Tax Policy & Public Finance Colloquium, and the NYU Tax Policy & Public Finance Colloquium for their comments and suggestions.

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TABLE OF CONTENTS

Introduction.........................................................................................................1 I. The Tax Treatment of Two and Twenty...................................................4 II. Why It Matters Now .................................................................................11 III. Deferral ......................................................................................................18

A. The Reluctance to Taxing Endowment..............................................19 B. Pooling of Labor and Capital Subsidy ................................................22 C. Measurement Concerns .........................................................................28

IV. Conversion.................................................................................................31 A. Below-Market Salary and Conversion................................................32 B. Compensating Service Partners............................................................33 C. The Entrepreneurial Risk Subsidy ......................................................35

V. Reform Alternatives...................................................................................38 A. The Status Quo.......................................................................................40 B. The Gergen Approach ..........................................................................41 C. The Forced Valuation Approach ........................................................42 D. The Cost-of-Capital Approach............................................................43 E. True Preferred Return Variation ........................................................45 F. Talent-Revealing Election....................................................................46 G. Summary.................................................................................................47

VI. Conclusion .................................................................................................48

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It’s like Moses brought down a third tablet from the Mount—and it said ‘2 and 20.’

— Christopher Ailman, California State Teachers’ Retirement System1

INTRODUCTION Private equity fund managers take a share of partnership

profits as the equity portion of their compensation. The industry standard package is “two and twenty.” The “two” refers to an annual management fee of two percent of the capital that investors have committed to the fund. The “twenty” refers to a twenty percent share of the future profits of the fund; this profits interest is also known as the “carry” or “carried interest.” The profits interest is what gives fund managers upside potential: If the fund does well, the managers share in the treasure. If the fund does badly, however, the manager can walk away. Any proceeds remaining at liquidation would be dis-tributed to the original investors, who hold the “capital interests” in the partnership.2

The tax rules treat partnership profits interests more favorably

than other forms of compensation, such as cash, stock, stock options, or a capital interest in a partnership. By getting paid in part with carry instead of cash, fund managers defer the income derived from their human capital. They are often also able to convert the character of that income from ordinary income into long-term capital gain, which is taxed at a lower rate. This conversion of labor income into capital gain is contrary to the general approach of the tax code, and it

1 As quoted in Neil Weinberg & Nathan Verdi, “Private Inequity,” FORBES, March 13, 2006. 2 For more general discussion on the financial structure of private equity and venture capital

funds, see Ulf Axelson, Per Stromberg & Michael Weisbach, Why are Buyouts Levered? The Financial Structure of Private Equity Funds (forthcoming, 2007 draft manuscript on file with the author); William A. Sahlman, The Structure and Governance of Venture Capital Organiza-tions, 27 J. FIN. ECON. 473 (1990).

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diverges from the treatment of other compensatory instruments. Partnership profits interests are treated more favorably than other economically similar methods of compensation, such as partnership capital interests, restricted stock, or at-the-money nonqualified stock options (the corporate equivalent of a partnership profits interest). The tax treatment of carry is roughly equivalent to that of Incentive Stock Options, or ISOs. Congress has limited ISO treatment to rela-tively modest amounts; the tax subsidy for partnership profits inter-ests is not similarly limited.3 A partnership profits interest is, under current law, the single most tax-efficient form of compensation avail-able without limitation to highly-paid executives.

The Article considers some possible law reform alternatives. I

have previously considered how the tax law may distort contract de-sign and the behavior of fund managers.4 Here, I focus on possible improvements in the tax law. One significant concern is the loss of ef-ficiency that occurs when investors and managers alter their contracts to provide compensation in a tax-advantaged form: Investors swal-low an increase in agency costs in order to allow fund managers to pay lower taxes, which in turn allows investors to pay less compensa-tion. Current law may also unnecessarily favor private investment funds, which are organized as partnerships, over investment banks and other financial intermediaries organized as corporations.5

Distributive justice is also a concern for those who believe in a

progressive or flat rate income tax system. This quirk in the partner-ship tax rules allows some of the richest workers in the country to pay tax on their labor income at a low effective rate. While the high pay of fund managers is well known, the tax gamesmanship is not. Changes in the investment world – the growth of private equity funds, the adoption of portable alpha strategies by institutional inves-tors, the increased capital gains preference, and more sophisticated tax planning – suggest that reconsideration of the partnership profits

3 Congress has limited ISO treatment to options on $100,000 worth of underlying stock, measured on the grant date, per employee per year. See § 422(d). The capital interests underly-ing the profits interests of fund managers, by comparison, generally range from $100 million to several billion dollars. A 20% profits interest is equivalent to an option on 20% of the fund; as-suming a modest fund size of $100 million and ten annual grants, the available incentive is about 20 times as large as would be allowed for corporate stock options under the ISO rules.

4 See Victor Fleischer, The Missing Preferred Return, 31 J. CORP. L. 77 (2005). 5 Private investment funds organize as partnerships or LLCs, rather than C Corporations, in

order to avoid paying an entity-level tax that would eat into investors’ returns.

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puzzle is overdue. Ironically, while the public and the media have focused on the “excessive” pay of public company CEOs, the evidence suggests that they are missing out on the real story. Almost nine times as many Wall Street managers earned over $100 million as public company CEOs; many of these top-earners on Wall Street are fund managers.6 And they pay tax on much of that income at a 15% rate, while the much-maligned public company CEOs, if nothing else, pay tax at a 35% rate on most of their income.

At the same time, populist outrage won’t necessarily lead us to

the right result from a tax policy perspective. The best tax policy de-sign depends on an exceedingly intricate and subtle set of considera-tions, including the extent to which one wishes to subsidize entrepre-neurial risk-taking, whether one believes the partnership tax rules are a sensible way to provide such a subsidy, one’s tolerance for complex rules, and on one’s willingness to tolerate the deadweight loss associ-ated with tax planning. Furthermore, increasing the tax rate on fund managers will encourage more of them, on the margins, to relocate operations overseas. This Article thus considers a menu of reform al-ternatives; the right answer depends on the relative weight that policy makers may choose to place on these various considerations. I do not take a strong position on which reform alternative is best. Instead, this Article illuminates what might make some alternatives more at-tractive than others.

This Article makes three principal contributions to the tax pol-

icy literature. First, it makes a practical contribution to the doctrinal tax literature by re-examining the partnership profits puzzle in the context of modern private equity finance. The tax policy implications of current law are quite different as applied in the real world of pri-vate equity – and the case for law reform is stronger – than one might think from reading the partnership tax rules in isolation, without con-sidering the institutional context in which they matter the most.

Second, this Article contributes to the broader tax policy litera-

ture by introducing a novel “cost-of-capital” approach to measuring the option value of equity. This approach approximates other eco-

6 See Steven N. Kaplan & Joshua Rauh, Wall Street and Main Street: What Contributes to the Rise in the Highest Incomes?, working paper available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=931280 .

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nomically similar arrangements, curbing the planning opportunity created when tax-indifferent counterparties offer compensatory at-the-money or out-of-the-money options or option-like instruments to taxable service providers. It also disaggregates the timing and charac-ter issues in a useful way.

Third, the Article offers a critical assessment of “sweat equity”

as a rationale for the preferential tax treatment of a profits interest in a partnership. The capital gains preference for investment capital is normally justified as a subsidy for taking on market risk, reducing the lock-in effect, or making up for the failure to index gains for inflation. None of those traditional justifications for the capital gains preference adequately capture the essence of the problem here. This Article in-stead hones in on entrepreneurial risk subsidy as a possible justifica-tion for treating the option value of partnership equity received in ex-change for future services in a tax-advantaged manner. Somewhat surprisingly, however, the tax advantage from working for oneself comes primarily from the ability to invest in one’s own business using pre-tax dollars rather than from the capital gains preference. This tax advantage, I argue, follows inevitably from our sensible reluctance to tax unrealized human capital, or endowment.

The Article is organized as follows. Following this introduc-

tion, Part I sets the stage with an overview of how private equity funds are taxed. Part II explains why addressing the long-standing partnership profits puzzle is so important today. Part III analyzes de-ferral issues, while Part IV analyzes conversion issues. Part V, build-ing on this analysis, offers a menu of reform alternatives.

I. THE TAX TREATMENT OF TWO AND TWENTY In order to keep the length of this Article manageable, I offer

only a brief description of the organization of private investment funds before turning to the tax treatment of fund manager compensa-tion.7 Funds are organized as limited partnerships or limited liability

7 For a more general description, see Sahlman, supra note 2; Ronald J. Gilson, Engineering a Venture Capital Market: Lessons from the American Experience, 55 STAN. L. REV. 1067 (2003). For more on the tax considerations that affect the compensation arrangement between fund managers and investors, see Fleischer, The Missing Preferred Return, supra note 4; Victor

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companies (LLCs) under state law. Investors become limited partners (LPs) in the partnerships and commit capital to the fund. A general partner (GP) manages the partnership in exchange for an annual management fee, often two percent of the fund’s committed capital. The GP also receives a share of any profits; this profit-sharing right is often called the “promote,” “carry,” or “carried interest.” The GP typi-cally receives twenty percent of the profits. The carried interest helps align the incentives of the GP with the goals of the LPs: because the GP can earn significant compensation if the fund performs well, the fund managers are driven to work harder and earn profits for the partnership as a whole. The GP also contributes some of its own capital to the fund so that it has some “skin in the game.” This amount ranges from one to five percent of the total amount in the fund.

GP

Private Equity Fund, L.P.

Limited Partners (LPs)

Portfolio Companies

Investment Professionals

Profits Interest Capital Interests

Management Fees

Fund Structure

Fleischer, The Rational Exuberance of Structuring Venture Capital Start-ups, 57 TAX L. REV. 137 (2004); Joseph Bankman, The Structure of Silicon Valley Start-Ups, 41 UCLA L. REV. 1737 (1994).

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After formation, the GP deploys the capital in the fund by investing in portfolio companies. In the case of venture capital funds, the portfolio companies are start-ups. In the case of private equity funds, the fund might buy out underperforming public companies, divisions of public companies, or privately-held businesses. After some period of time (often between two to seven years) the fund sells its interest in the portfolio company to a strategic or financial buyer, or takes it public and sells its securities in a secondary offering. The proceeds are then distributed to the partners, and when all the partnership’s invest-ments have been exited, the fund itself liquidates. The carried interest creates a powerful financial incentive for the GP. The GP is itself a partnership or LLC with a small number of professionals as members. The GP receives a management fee that covers administrative overhead, diligence and operating costs, and pays the managers’ salaries. The management fee is fixed and does not depend on the performance of the fund. The carry, on the other hand, is performance-based. Because private equity funds are leanly staffed, a carried interest worth millions of dollars may be split among just a handful of individuals. The tax treatment of a fund manager’s compensation depends on the form in which it is received. The management fee is treated as ordinary income to the GP, taken into income as it is received on an annual or quarterly basis. (As I discuss later, many fund managers take advantage of planning techniques to convert these tax-disadvantaged management fees into tax-advantaged carry.)

The treatment of carry is more complicated. When a GP re-ceives a profits interest in a partnership upon the formation of a fund, that receipt is not treated as a taxable event. This treatment seems counter-intuitive. There is little question that the GP receives some-thing of value at the moment the partnership agreement is signed. But valuation and other considerations prevent the tax law from treating this receipt as a taxable event. This creates a conceptual ten-sion. On the one hand, a carried interest is a valuable piece of prop-erty that often turns out to be worth millions and even hundreds of millions of dollars. On the other hand, it’s difficult to pin down a fair market value at the time of grant because the partnership interest is typically non-transferable, highly speculative, and depends on the ef-forts of the partners themselves (and thus would have a lower value

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in the hands of an arms-length buyer). How should we treat this as-pect of the transaction for tax purposes? In the context of corporate equity compensation, section 83 puts executives to a choice: they may make a section 83(b) election and recognize income immediately on the current value of the prop-erty, or they can wait-and-see. If they make the election, any further gain or loss is capital gain or loss. If they wait-and-see, however, the character of the income is ordinary. From a revenue standpoint, the stakes of this choice are fairly low: any conversion or deferral of in-come, which lowers the executives’ tax bill, is roughly offset by the conversion or deferral of the corporate deduction for compensation paid.

The treatment of partnership equity is different than corpo-rate equity, and it’s not entirely consistent with these broad section 83 principles. The tax law tackles the problem of partnership equity by dividing partnership interests into two categories: capital interests and profits interests. A profits interest is an interest that gives the partner certain rights in the partnership (thus distinguishing it from an option to acquire a partnership interest) but has no current liquidation value. A capital interest gives the partner certain rights in the partnership and also has a positive current liquidation value. When a partner re-ceives a capital interest in a partnership in exchange for services, the partner has immediate taxable income on the value of the interest. Determining the proper treatment of a profits interest is more diffi-cult, however. It lacks any liquidation value, making its value diffi-cult to determine. This categorization is analytically convenient, but it is deceptively simple, somewhat inaccurate from an economic standpoint, and it creates planning opportunities that are widely ex-ploited.

Timing. A bit more explication of the tax background may be

helpful. The tax treatment of a profits interest in a partnership has been fairly consistent historically. There was a period of uncertainty following the 1971 case of Diamond vs. Commissioner, where the Tax Court (affirmed by the Seventh Circuit) held that the receipt of a prof-its interest “with determinable market value” is taxable income.8 A profits interest in a partnership rarely has a determinable market

8 See Diamond v. Commissioner, 492 F.2d 286, 291 (7th Cir. 1974), aff’g 56 T.C. 530 (1971).

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value, however; tax lawyers remained comfortable advising clients that the receipt of a profits interest was not normally a taxable event. The IRS later provided a safe harbor, in Revenue Procedure 93-27, for most partnership profits interests.9 The Treasury Department has proposed regulations (and an accompanying notice) that would reaffirm the status quo.10 The pro-posed regulations, like Rev. Proc. 93-27, require that, in order for the receipt of a profits interest to be treated as a non-taxable event, the partnership’s income stream cannot be substantially certain and pre-dictable, that the partnership cannot be publicly traded, and that the interest cannot be disposed of within two years of receipt. The typical carried interest finds ample shelter in the proposed regulations. The interest has no current liquidation value; if the fund were liquidated immediately, all of the drawn-down capital would be returned to the LPs. And while the carried interest has value, it is not related to a “substantially certain and predictable stream of income from partner-ship assets.” On the contrary, the amount of carry is uncertain and unpredictable.11 The receipt of a partnership interest, therefore, is not a taxable event under current law. The timing advantage continues as the partnership operates. The partnership holds securities in its portfolio companies; these securities are often illiquid and difficult to value. Like any other investor, the partnership then enjoys the benefit (or detriment) of the realization doctrine, which allows taxpayers to defer gain or loss until investments are actually sold (or until some other re-alization event occurs). One might think that the timing effect of the

9 See Rev. Proc. 93-27, 1993-2 C.B. 343. Rev. Proc. 93-27 spelled out the limits of this safe harbor. To qualify, the profits interest must not relate to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease, must not be disposed of within two years of receipt, and the partnership must not be publicly traded. See id. See also Rev. Proc. 2001-43, 2001-2 C.B. 191 (holding that a profits interest that is not substantially vested does trigger a taxable event when restrictions lapse; recipients need not file protective 83(b) elections). Rev. Proc. 93-27 defines a capital in-terest as an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. See Rev. Proc. 93-27, 1993-2 C.B. 343. A profits interest is defined as a partnership interest other than a capital interest. See id. The determination as to whether an interest is a capital interest is made at the time of receipt of the partnership interest. See id.

10 See 70 Fed. Reg. 29675 (May 24, 2005). 11 See Laura Cunningham, Taxing Partnership Interests Exchanged for Services, 47 TAX. L.

REV. 247, 252 (1991).

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realization doctrine would even out. Taxable losses are deferred, just as gains are. Because the GP receives a substantial share of the eco-nomic gains but only a small share of the fund’s losses (the one to five percent “skin in the game”), however, the realization doctrine works to the benefit of GPs.12 In sum, the tax law thus provides a timing benefit for GPs by allowing deferral on their compensation so long as the compensation is structured as a profits interest and not a capital interest in the partnership.13 Character. By treating the carried interest as investment in-come rather than service income, the tax law allows the character of realized gains to be treated as capital gain rather than ordinary in-come. Compensation for services normally gives rise to ordinary in-come. In the partnership context, characterizing a payment for ser-vices can be a difficult issue when the recipient, like the fund manager here, is a partner in the partnership. Section 83 provides the general rule that property received in connection with the performance of ser-vices is income.14 Section 707 addresses payments from a partnership to a partner. So long as the payment is made to the partner in its ca-pacity as a partner (and not as an employee) and is determined by ref-erence to the income of the partnership (i.e. is not guaranteed), then

12 The presence of tax-indifferent LP investors who don’t mind deferring tax losses makes this deferral much more significant from a revenue standpoint than it would otherwise be.

13 The net result is also more advantageous than parallel rules for executive compensation with corporate stock. As two commentators have explained, the valuation rules for corporate stock are more stringent.

The treatment of SP’s receipt of a profits interest under Rev. Proc. 93-27 is significantly better than the treatment of an employee’s receipt of corporate stock. While the economics of a prof-its interest can be approximated in the corporate context by giving investors preferred stock for most of their invested capital and selling investors and the employee "cheap" common stock, the employee will recognize OI under Code §83 equal to the excess of common stock’s FMV (not liquidation value) over the amount paid for such stock. In addition, if the common stock layer is too thin, there may be risk that value could be reallocated from the preferred stock to the common stock, creating additional OI for the employee.

William R. Welke & Olga A. Loy, Compensating the Service Partner with Partnership Equity: Code § 83 and Other Issues, 79 Taxes 94 (2001)

14 See § 83(a). If one assumes that a partnership profits interest is property, then a simple read-ing of § 83 suggests that the GP should be taxed immediately on the fair market value of the carried interest. It is far from clear, however, that Congress intended this reading when it en-acted § 83. Cite to legislative history from senate finance committee; Cunningham, supra note 11; New York State Bar Association, Tax Section, Report on the Proposed Regulations and Revenue Procedure Relating to Partnership Equity Transferred in Connection with the Per-formance of Services (October 26, 2005).

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the payment will be respected as a payout of a distributable share of partnership income rather than salary.15 In colloquial terms, if a ser-vice partner receives a cash salary and an at-the-money or out-of-the-money equity “kicker,” the kicker is treated as investment income, not labor income.

The tax law therefore treats the initial receipt of the carry as a non-event, and it then treats later distributions of cash or securities under the terms of the carried interest as it would any other distribut-able share of income from a partnership. Because partnerships are pass-through entities, the character of the income determined at the entity level is preserved as it is received by the partnership and dis-tributed to the partners. With the notable exception of hedge funds that actively trade securities, most private investment funds generate income by selling the securities of portfolio companies, which nor-mally gives rise to long-term capital gain.

The impact of these rules on the other partners varies from fund to fund. Treating the receipt of a profits interest by the GP as a non-event for tax purposes is good for the GP but bad for taxable LPs, as the partnership cannot take a deduction for the value of the interest paid to the GP, which in turn means that the LPs lose the benefit of that current deduction. If the GP and LPs have the same marginal tax rates, then the tax benefit to the GP is perfectly offset by the tax detriment to the LPs. As discussed in more detail below, how-ever, many LPs are tax-exempt. It is therefore rational for many funds to exploit the gap between the economics of the carried interest and its treatment for tax purposes.

In sum, a profits interest in a partnership is treated more like a

financial investment rather than payment for services rendered. Partnership profits are treated as a return on investment capital, not a return on human capital. In Parts III and IV, I explore why that is the case. Before turning to the justifications for deferral and conver-

15 Arguably, the initial receipt of the carried interest is better characterized as itself a guaran-teed payment (as it is made before the partnership shows any profit or loss). See Cunningham, supra note 11, at 267 (“Because the value of a partnership interest received by a service partner, whether capital or profits, invariably is dependent upon the anticipated income of the partner-ship, the mere fact that the right to reversion of the capital has been stripped from the interest does not convert the property interest represented by the profits interest into a distributive share of partnership income.”)

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sion, however, it is worth highlighting why this issue is worthy of at-tention.

II. WHY IT MATTERS NOW

The scholarly literature on the tax treatment of a profits inter-

est in a partnership is extensive.16 The debate sometimes has the air of an academic parlor game. Setting aside a couple of hiccups – the Diamond and Campbell cases familiar to partnership tax jocks – three generations of tax lawyers have been perfectly comfortable advising their clients that the grant of a profits interest in a partnership does not give rise to immediate taxable income.17 The Treasury Depart-ment’s proposed regulations would quasi-codify this longstanding rule. Why reopen the debate? I argue here that that the increased use of partnership profits as a method of executive compensation in the context of private investment funds suggests the need for reform. The investment world has changed since the days when mortgage broker Sol Diamond sold his partnership interest for $40,000.

The key development has been the growth and professionali-

zation of the private equity industry. The private equity revolution has shaped the source of investment capital, spurred an increase in demand for the services of intermediaries, and allowed portable alpha strategies (defined and discussed below) to develop. These institu-tional changes have put increasing pressure on the partnership tax rules, which were designed with small businesses in mind. Games-manship has increased. Meanwhile, congressional policy towards ex-ecutive compensation in the corporate arena tightened up following the Enron scandals; the gap between the treatment of corporate eq-uity and partnership equity is increasing and, if not addressed, will

16 See, e.g., Cunningham, supra note 11; Leo Schmolka, Taxing Partnership Interests Ex-changed for Services: Let Diamond/Campbell Quietly Die, 47 TAX L. REV. 287 (1991); Martin B. Cowan, Receipt of an Interest in Partnership Profits in Consideration for Services: The Diamond Case, 27 TAX L. REV. 161 (1972); Hortenstine & Ford, Receipt of a Partnership Inter-est for Services: A Controversy That Will Not Die, 65 TAXES 880 (1987); Sheldon Banoff, Con-versions of Services Into Property Interests: Choice of Form of Business, 61 TAXES 844 (1983).

17 Subchapter K was enacted in 1954. Even before then, under common law rules, a profits interest was treated at least as favorably as it us under current law. See NYSBA report, supra note 14.

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encourage even more capital to shift from the public markets into pri-vate equity.

Source of Investment Capital. The first factor that warrants reconsideration of the partnership profits puzzle is the change in pri-vate equity’s source of investment capital. In the 1950s and 1960s, the private equity industry was populated mostly by individuals. The industry had a maverick culture. It attracted risk-seeking investment cowboys. Today, by contrast, even the most stolid institutional inves-tors include alternative assets like venture capital funds, private eq-uity funds, and hedge funds in their portfolios. The most powerful investors, such as large public pension funds and university endow-ments, may invest as much as half of their portfolio in alternative as-sets.18

This shift in the source of investment capital creates some tax

planning opportunities. Large institutional investors are long-term investors, which creates an appetite for illiquid investments like pri-vate equity that offer an illiquidity premium. The lengthy time hori-zon of these investments increases the value of deferring compensa-tion for tax purposes. More importantly, many of these institutional investors are tax-exempt, such as pension funds and university en-dowments. Substitute taxation is not available as a backstop to pre-vent exploitation of gaps in the tax base created by the realization doctrine and conversion of ordinary income into capital gain.19

Increased use of intermediaries. The second factor that war-

rants reconsideration of the partnership profits puzzle is the increased

18 The shift began with modern portfolio theory and accelerated with the Department of La-bor’s “prudent man” ruling in 1979, which allowed institutional investors to include high-risk, high-return investments as a part of a diversified portfolio.

19 In the corporate context, substitute taxation is essential to bringing the tax treatment of de-ferred compensation close to the economics of the arrangement. Consider your typical corpo-rate executive who receives non-qualified stock options. Those stock options have economic value when they are received, yet the executive defers recognition until the options vest. This deferral is valuable to the executive. But it is costly to the employer, which must defer the cor-responding deduction. Thus corporate equity compensation is not enormously tax-advantaged in the usual case. Corporate equity compensation is tax-advantaged if the corporation shorts its own stock to hedge the future obligation, or if the executive’s marginal tax rate is higher than the corporation’s marginal tax rate. See David I. Walker, Is Equity Compensation Tax-Advantaged?, 84 B. U. L. REV. 695 (2004); Merton H. Miller & Myron S. Scholes, Executive Compensation, Taxes and Incentives (1982); see also Gregg Polsky & Ethan Yale, Reforming the Taxation of Deferred Compensation, N.C. L. REV. (forthcoming 2007).

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use of intermediaries. As the industry has professionalized, the de-mand for private equity has increased. Smaller institutions, family of-fices, and high net worth individuals now seek access to the industry. Funds-of-funds and consultants have stepped in to provide these ser-vices. In addition to providing increased access to funds, these inter-mediaries screen funds to find the best opportunities and monitor the behavior of GPs in the underlying funds. In exchange, they often re-ceive a share of the profits – a carried interest of their own.20 Each year, more and more financial intermediaries take advantage of the tax treatment of two and twenty.

Portable Alpha. The third factor that warrants reconsidera-

tion of the partnership profits puzzle is the pursuit of a new invest-ment strategy by institutional investors. Tax scholars have generally discussed the partnership profits puzzle in the context of small busi-nesses and real estate partnerships. But the issue arises perhaps most often, and certainly with greatest consequence, for private investment funds.21 Thanks to recent growth in the industry, these funds now manage more than a trillion dollars of investment capital.22 Because of economies of scale, one might expect to see a small increase in abso-lute compensation but a decrease in proportion to the size of the fund. Instead, “two and twenty” has remained the industry standard.23 Something is fueling demand for the services that private equity fund managers provide.

20 Private investment funds (including most funds-of-funds) are engineered to be exempt from the Investment Company Act of 1940. As a result, the fund managers may be compensated by receiving a share of the profits from the fund. In contrast, mutual fund managers may not re-ceive a share of the profits, but rather must be paid a percentage of the assets of the fund (like the management fee in a private equity fund). As capital shifts away from mutual funds into private investment funds, more compensation takes the form of tax-advantaged carry, and less takes the form of tax-disadvantaged management fees.

21 See NYSBA Report, supra note 14. 22 See Axelson et al., supra note 2, at 2. Discussing the problem in the context of the Diamond

and Campbell cases is like drafting stock dividend rules to accommodate Myrtle Macomber. See Eisner v. Macomber, 252 U.S. 189 (1920). Human stories and judicial opinions make the problem more accessible for students and scholars, but they can also distort public policy con-siderations. See also Growing Pains, in Special Report: Hedge Funds, THE ECONOMIST, March 4, 2006, at 63, 64 (“There are more than 8,000 hedge funds today, with more than $1 tril-lion of assets under management.”) Between hedge funds, private equity funds, and venture capital funds, the amount of investment capital flowing through the two and twenty structure easily exceeds two trillion dollars.

23 In larger funds one does tend to observe a lower management fee.

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The growing adoption of “portable alpha” strategies among

institutional investors helps explain the increased demand for the ser-vices of private investment fund managers, which in turn increases the dollar amount of compensation they receive.24 Portable alpha is an investment strategy that emphasizes seeking positive, risk-adjusted returns (alpha) rather than simply managing risk through portfolio al-location. Modern portfolio theory, in its simplest form, cautions in-vestors to maintain a diversified mix of stock, bonds, and cash. Only a small amount of assets would be placed in risky alternative asset classes like real estate, venture capital, buyout funds and hedge funds. According to portable alpha proponents, many investors fool them-selves into thinking that because they achieve high absolute returns, they are doing well. In reality, most of the return simply reflects a re-turn for bearing market risk (beta). What many investors have amounts to little more than an expensive index fund. A portable al-pha strategy, by contrast, recognizes that the real value comes from risk-adjusted returns. When alpha opportunities arise, they should be exploited fully; the remainder of the portfolio can be cheaply adjusted, using derivatives, to increase or decrease beta. (The availability of ad-justing beta through the use of derivatives is what makes the alpha “portable.”)25

Regulatory Gamesmanship. The fourth factor which makes

reconsideration of current law more pressing is the increase in regula-tory gamesmanship. Many investment funds exploit the tax treat-ment of a profits interest in a partnership by failing to index the measurement of profits to an interest rate or other reflection of the cost of capital. This phenomenon, which I call the “missing preferred return,” allows fund managers to maximize the present value of the carried interest and accept lower management fees than they other-wise would, thereby maximizing the tax advantage.26

24 One might ask why, if demand is increasing, supply does not follow. It does, of course – there are more fund managers than there used to be – but because it takes some time to develop a reputation, there is a lag. See Douglas Cumming & Jeffrey Macintosh, Boom, Bust & Litiga-tion in Venture Capital Finance, 40 WILLAMETTE L. REV. 867 (2004).

25 Alpha requires two inputs; the talent of the managers who can create it, and the capital of investors to implement the strategy. The two parties share the expected returns; investors are quite rationally willing to share large amounts of the abnormal returns with the fund managers who create them.

26 See Fleischer, The Missing Preferred Return, supra note 4. Buyout funds and many hedge funds use a hurdle rate, which also increases tax savings compared to a true preferred return.

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Buyout funds and most other investment funds use a form of

preferred return. Rather than a true preferred return, however, most use a hurdle rate. Until a fund clears a hurdle of, say, 8%, any profits are allocated to the LPs. Once the hurdle is cleared, profits are then allocated disproportionately to the GP until it catches up to the point where it would have been had it received twenty percent of the profits from the first dollar. Moral hazard concerns prevent private equity funds from doing away with the preferred return entirely. Still, by us-ing a hurdle rate – also known as a disappearing preferred return – rather than a true preferred return, profits interests are larger than they would otherwise be, raising the stakes on the tax question.27

Conversion of management fees into capital gain. GPs have

become more aggressive in converting management fees, which give rise to ordinary income, into additional carry. This planning strategy defers income and may ultimately convert labor income into capital gain. Some GPs opt to reduce the management fee in exchange for an enhanced allocation of fund profits. The choice may be made up front, triggered upon certain conditions, during formation of the fund; in other cases the GP may reserve the right to periodically waive the management fee in exchange for an enhanced allocation of fund prof-its during the next fiscal year of the fund.28

There is a trade-off between tax risk and entrepreneurial risk. So long as there is some economic risk that the GP may not receive sufficient allocations of future profit to make up for the foregone management fee, most practitioners believe that the constructive re-ceipt doctrine will not apply, and future distributions will be re-spected as distributions out of partnership profits.29

27 Whether the design of the preferred return is explained by tax motivations is a question I take up elsewhere. Regardless of whether the design is tax-motivated, there is no question that GPs are maximizing the amount of compensation they receive in carried interest. Nor is there any question that (with the exception of certain hedge funds) distributions typically give rise to long-term capital gain. Thus, even if one thinks that tax somehow has no influence on the design of preferred returns, the tax consequences raise considerations of distributional equity. A large amount of profits allocated to GPs represents the time value of money, received in exchange for services, yet it is treated as a risky investment return and afforded capital gains treatment.

28 See Jack S. Levin, STRUCTURING VENTURE CAPITAL, PRIVATE EQUITY, AND ENTREPRE-

NEURIAL TRANSACTIONS at 10-13 (2004 ed.). 29 See id. at 10-13; see also Wilson Sonsini Goodrich & Rosati, Converting Management Fees

in Carried Interest: Tax Benefits vs. Economic Risks (2001) (on file with the author).

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The entrepreneurial risk may be smaller than it appears at first glance, depending on the underlying portfolio of the fund. If the management fee is waived in favor an increased profit share in the following year, and the GP knows that an investment will be realized that is likely to generate sufficient profits, then the constructive receipt doctrine should arguably apply. To my knowledge, however, there is no published authority providing guidance as to how much economic risk justifies deferral in this context.30

Lastly, GPs also take advantage of the current tax rules by converting management fees into capital interests. Recall that GPs are expected to have some “skin in the game” in the form of their own capital contributed to the fund. This gives GPs some downside risk and partially counterbalances the risk-seeking incentive that the car-ried interest provides. Rather than contribute after-tax dollars, how-ever, GPs again convert management fees into investment capital. In a technique known as a “cashless capital contribution,” GPs forego a portion of the management fee that would be otherwise due, using this cash to fund the GP capital account. This arrangement slightly increases agency costs (as it reduces the downside risk in the initial years of the fund), but the tax savings more than offset the increase in agency costs. (The tax savings can effectively be shared with the LPs by reducing management fees slightly.)

Distortion of investment behavior. Lastly, the problem war-

rants renewed attention because the treatment of a profits interest in a partnership represents a striking departure from the broader design of executive compensation tax policy. Economically similar transactions are taxed differently. Investors structure deals to take advantage of the different tax treatment. Generally speaking, this sort of tax plan-ning is thought to decrease social welfare by creating deadweight loss, that is, the loss created by inefficient allocation of resources. Specifi-cally, the tax-advantaged nature of partnership profits interests may encourage more investments to take place through private investment funds, which are taxed as partnerships, rather than through publicly-traded entities, which are generally taxed as corporations.31

30 Cf. Notice 2005-1 (discussing non-application of 409A to profits interest in a partnership). 31 As I discuss in more detail later, there may be offsetting positive social externalities that

may justify the disparate treatment of partnership equity. As an initial matter, however, it is

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Section 83 is the cornerstone of tax policy regarding executive

compensation. Broadly speaking, § 83 requires that property received in exchange for services be treated as ordinary income. When an ex-ecutive performs services in exchange for an unfunded, unsecured promise to pay, or when she receives property that is difficult to value because of vesting requirements, compensation may be deferred. When compensation is received, however, the full amount must be treated as ordinary income. The treatment of partnership profits in-terests departs from this basic framework.

The clearest way to understand the point is to compare the

treatment of a partnership profits interest to a nonqualified stock op-tion (NQSO). When an executive exercises an option and sells the stock, she recognizes ordinary income to the extent that the market price of the stock exceeds the strike price. By contrast, a fund man-ager’s distributions are typically taxed at capital gains rates. A profits interest, in other words, is treated not like its economic sibling, an NQSO, but is instead treated in the executive’s hands like an Incen-tive Stock Option (ISO). ISOs are subject to a $100,000 per year limi-tation, reflecting a Congressional intent to limit the subsidy. Carried interests, by contrast, are not subject to any limitation.

The disparity between the treatment of corporate and part-

nership equity has grown recently. Section 409A, enacted in response to deferred compensation abuses associated with the Enron scandals, has forced more honest valuations of grants of common stock. Regu-lations under § 409A, however, exempt the grant of a profits interest in a partnership from similar scrutiny. As explained in more detail in Appendix A, this disparity in tax treatment gives rise to deadweight loss, although the distortion may not be as severe as one might think at first glance.32 [N.B. I’m still revising Appendix A, which isn’t yet attached. It shows that the disparity in tax treatment is most impor-

useful to describe the disparity before exploring whether the distortions that follow might none-theless be justified on policy grounds.

32 Some evidence of distortions of the market may be found in the behavior of the key market

participants. In response to labor market pressures, investment banks (which are mostly or-ganized as corporations) have begun to set up “side” funds to allow their fund managers to re-ceive a profits interest in funds that invest in portfolio companies so that they, too, can benefit from the tax treatment of two and twenty. See Berg & Serebransky. The investment bank still receives some fees, but the human capital provided by its employees is taxed at a lower rate.

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tant when portfolio companies have low effective tax rates, as with most venture capital-backed start-ups and many under-performing or debt-laden companies acquired by buyout shops. For companies with high effective tax rates, the ability to deduct managerial compensation is more valuable, which makes the corporate form more attractive.]

Summary. Together these institutional factors have contrib-

uted to an important but largely overlooked shift in executive com-pensation strategy in the financial services industry. The most tal-ented financial minds among us – those whose status is measured by whether they are “airplane rich” – are increasingly leaving investment banks and other corporate employers to start or join private invest-ment funds organized as partnerships.33 The partnership profits puz-zle has greater significance than ever before, and while this fact is well known within the private equity industry, it has received little atten-tion from academics or policymakers.34

III. DEFERRAL The concept that a fund manager can receive a profits interest in a partnership without facing immediate tax on the grant may not sit well with one’s intuitive sense of fair play. These profits interests have enormous economic value. Tax Notes columnist Lee Sheppard characterizes Treasury’s proposed regulations as a “massive give-away.”35

But the question is more complicated than it might seem at

first glance. Historically there has been broad agreement among tax scholars that deferral is appropriate for a profits interest received in exchange for future services. The underlying principles in support of deferral are (1) a philosophical resistance to taxing endowment and/or taxing unrealized human capital, (2) a subsidy for the pooling of labor

33 You are airplane rich if you own your own private jet. 34 The issue attracted attention on Capitol Hill and in the media while this paper was circulat-

ing in draft form. See Editorial, “Taxing Private Equity,” NEW YORK TIMES, April 2, 2007 (cit-ing this paper as “[a]dding grist to lawmakers’ skepticism,” notably Senator Max Baucus, the Democratic chairman of the Finance Committee, and Senator Charles Grassley, the commit-tee’s top Republican).

35 Cite to Tax Notes, March 2006.

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and capital, and (3) measurement/valuation concerns. The objections to taxing endowment are easily dealt with by considering accrual taxation alternatives. Encouraging the partnership form as a conven-ient method of pooling together labor and capital is somewhat more appealing as a justification for current law, although the normative underpinning for such a subsidy is unclear. Nor is it self-evident that such a subsidy, if desirable, should be extended to large investment partnerships. Measurement concerns are certainly valid; I offer a novel method for dealing with such concerns in part C below.

A. The Reluctance to Taxing Endowment

The deferral of income associated with the receipt of a profits

interest is sometimes explained by the same objections that scholars have toward taxing endowment. Endowment taxation calls for tax-ing people based on their ability or talent. A pure endowment tax base would tax both realized and unrealized human capital.

The primary attraction of using endowment as an ideal tax

base is that by taxing ability rather than earned income, it eliminates the incentive problem created by the fact that utility derived from lei-sure activities is untaxed. Endowment taxation reduces or eliminates the labor-leisure tax distortion and the deadweight loss that comes with it. Endowment taxation would, for example, eliminate the tax advantage of the currently untaxed psychological, status, and identity benefits of being a law professor – such as the intellectual stimulation of the job, the joy of teaching, academic freedom, and lifetime job se-curity. On the margins, an endowment tax scheme would encourage workers to labor in the sector which the market compensation is high-est, which in turn allocates labor resources more efficiently, reducing deadweight loss.

Using endowment as a tax base can give rise to a so-called

“talent slavery” objection. In a pure endowment tax system, a tal-ented lawyer graduating from Columbia Law School would be taxed on her anticipated future profits at a Wall Street law firm. She would have to pay this tax even if she quits law firm practice to become a law professor or work for a charitable organization – after all, the tax is based on one’s ability to earn income, not one’s actual earned in-come.

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Few tax scholars (if any) support a pure system of taxing en-

dowment.36 There are powerful liberal egalitarian objections to tax-ing endowment, mostly rooted in the talent-slavery objection. Equal-ity of opportunity is important, but so too is the autonomy of the most talented among us.37 Human beings were not created simply to cre-ate wealth or even simply to maximize personal or social utility; the government should play only a limited role in dictating the path they choose to follow.

These liberal egalitarian objections to endowment taxation

help explain why we do not tax a profits interest in a partnership re-ceived in exchange for future services. In the partnership profits tax literature, which predates the recent revival of academic interest in endowment taxation, the concern is articulated as an objection to tax-ing unrealized human capital. Professor Rebecca Rudnick character-ized the principle of taxing human capital only as income is realized as one of the four fundamental premises of partnership tax.38 “Hu-man capital,” she noted, “is not normally taxed on its expectancy value.”39 It’s unfair to tax someone today on what they have the abil-ity to do tomorrow; taxing human capital on its expected value com-modifies human capital by treating it like investment capital. It may provide a more accurate assessment of the value of human capital (and thus, arguably, a sounder tax base) but carries a high perceived cost.

Similarly, Professor Mark Gergen has argued that taxing un-

realized human capital is inconsistent with our system of income taxa-tion. “No one thinks, for example, that a person making partner in a

36 See generally Lawrence Zelenak, Taxing Endowment, 55 DUKE L. J. 1145 (2006). See also Daniel Shaviro, Endowment and Inequality, in TAX JUSTICE: THE ONGOING DEBATE (Thorndike & Ventry eds., 2002); Kirk J. Stark, Enslaving the Beachcomber: Some Thoughts on the Liberty Objections to Endowment Taxation, 18 CANADIAN J. L. & JURIS. 47 (2005); David Hasen, Liberalism and Ability Taxation, (forthcoming); Linda Sugin, Why Endowment Taxa-tion is Unjust (2007 draft manuscript on file with the author).

37 See, e.g., Liam Murphy & Thomas Nagel, THE MYTH OF OWNERSHIP: TAXES AND JUSTICE 123 (2002); John Rawls, JUSTICE AS FAIRNESS: A RESTATEMENT 158 (2001); David Hasen, The Illiberality of Human Endowment Taxation (draft manuscript).

38 See Rebecca S. Rudnick, Enforcing the Fundamental Premises of Partnership Taxation, 22 HOFSTRA L. REV. 229, 232-33 (1993) (“The four major premises of Subchapter K state that … (3) human capital providers are not taxed on the receipt of interests in profits if they are of merely speculative value[.]”)

39 See id. at 350.

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law firm should pay tax at that time on the discounted present value of her future earnings.”40 Professor Gergen acknowledges that the profits interest puzzle can be more complicated than the simple anal-ogy to a law firm associate making partner, and he identifies weak-nesses in the usual arguments about taxing human capital. In the end, however, he concludes that equity holds up the bottommost tur-tle.41 “Perhaps we cross over a line,” he explains, “where valuation or other problems are sufficiently difficult that wealth in the form of human capital cannot be taxed in most cases, and so, for the sake of equity, we choose to tax it in no cases.”

Professor Gergen’s objections to taxing unrealized human

capital are more pragmatic than normative. He emphasizes the im-portance of consistency, and so would draw a bright line between the exchange of cash in exchange for future services (which he would treat as a taxable event) and any other form of property, including a profits interest, which he would not. “Whatever the reason, the real-ity is that we do not tax human capital, and, unless we want to radi-cally change the tax, consistency requires that we not tax rights short of cash given in anticipation of future services.”42 Professor Gergen’s approach, while elegant and practical, creates its own inconsistencies, namely by treating economic equivalents differently.

The accrual tax alternative. The parade of horribles associ-ated with taxing endowment should not be used to justify a blanket

40 Mark Gergen, Pooling or Exchange: The Taxation of Joint Ventures Between Labor and Capital, 44 TAX L. REV. 519, 544 (1989).

41 See Stephen Hawking, A BRIEF HISTORY OF TIME, describing an anecdote about an en-counter between a scientist and a little old lady:

A well-known scientist (some say it was Bertrand Russell) once gave a public lec-ture on astronomy. He described how the Earth orbits around the sun and how the sun, in turn, orbits around the centre of a vast collection of stars called our galaxy. At the end of the lecture, a little old lady at the back of the room got up and said: "What you have told us is rubbish. The world is really a flat plate supported on the back of a giant tortoise." The scientist gave a superior smile before replying, "What is the tortoise standing on?" "You're very clever, young man, very clever," said the old lady. "But it's turtles all the way down!"

42 Gergen, Pooling, supra note 40, at 550.

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rule that does not tax unrealized human capital. Accrual-based in-come taxation may serve as an attractive middle ground between en-dowment taxation and transaction-based income taxation. Even if we don’t want to tax human capital on its expectancy value, we may want to approximate the current value of returns on human capital as they accrue, rather than waiting until those returns are actually real-ized in the form of cash.

Because accrual income taxation taxes partners only so long as

they remain in their chosen profession, it avoids the “talent slavery” or “enslaving the beachcomber” objections to endowment taxation. Elite lawyers could still work for the Southern Center for Human Rights if they so choose. A Harvard MBA would not be forced to toil away at a private equity fund in order to pay off a tax imposed on her ability to perform the work. But once she chooses the path of riches, there is nothing normatively objectionable about taxing the returns from her human capital on an annual basis rather than on a transac-tional basis (i.e. whenever the partnership liquidates investments).43 One might object to the added complexity of accrual-based taxation of partnership profits, of course, but it suffices at this stage of the ar-gument to note that talent-slavery is a red herring.

B. Pooling of Labor and Capital Subsidy

It is often said that the appeal of the partnership form is its

convenience as a method of pooling together labor and capital. The corporate form can be rigid, for example, by demanding one class of stock (if organized as an S Corporation), or extracting an entity-level tax on profits (if organized as a C Corporation). The corporate form is said to be like a lobster pot: easy to enter, difficult to live in, and pain-ful to get out of.44 The partnership form, on the other hand, allows considerable flexibility to enter and exit without incurring an extra taxable recognition event.

43 The concern about taxing unrealized human capital could also be addressed through a spe-cial surtax on income at the point of realization.

44 See Peracchi v. Commissioner, 143 F.3d 487 (9th Cir. 1998), citing Boris I. Bittker & James Eustice, FEDERAL INCOME TAXATION OF CORPORATIONS AND SHAREHOLDERS, ¶ 2.01[3] .

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Easiest Hardest

Pooling of Labor and Capital

Sole Proprietorship Partnership Corporation

Individual Aggregate / Entity Entity

Commentators have used the desirability of allowing the pool-

ing of labor and capital to justify the tax treatment of a profits interest in a partnership. But this policy goal of facilitating pooling lacks a solid normative justification. Pooling of labor and capital can take place in any entity form, from a sole proprietorship to a publicly-traded corporation. At one end of the spectrum is a sole proprietor-ship funded entirely with debt. There is no entity, and the owner/laborer is, of course, taxed as an individual. At the other end of the spectrum is a C Corporation, taxed at both the entity level and in-dividual shareholder level. In the middle stands the partnership, which is sometimes treated as an aggregate of individuals, and some-times as an entity. Compared to a corporation, it’s easier for investors and founders to get into and get out of without incurring tax. But it’s not as simple as a sole proprietorship.

Line-drawing rules distinguishing between pooling transac-

tions (treated as non-recognition events) and exchange transactions (treated as recognition events) will tend to be arbitrary. In the context of partnership tax, the current rules treat the receipt of a profits inter-est as a pooling event, but the receipt of a capital interest as an ex-change (like the receipt of other forms of property, like stock or cash, received in exchange for services). Professor Laura Cunningham’s 1991 Tax Law Review article challenged the logic of distinguishing be-tween a capital interest and a profits interest in a partnership. There is no economic distinction, she noted, between a capital interest and a profits interest that would justify taxing the two interests differently.45

45 Cunningham, supra note 11.

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Because the value of a profits interest, like the value of a capital inter-est, depends on the value and expected return of the partnership’s underlying assets, she concludes that the distinction is without a dif-ference. Treating one as “speculative” simply because it has no cur-rent liquidation value does not bring one closer to economic reality.46

Professor Cunningham nonetheless ultimately agreed with the status quo treatment of a partnership profits interest when the profits interest is granted in exchange for future services.47 The policy against taxation of unrealized human capital, she explains, “would dictate against taxation until realization occurs. Nothing in subchap-ter K changes this result: In fact, subchapter K arguably was in-tended to encourage just this type of pooling of labor and capital by staying current tax consequences until the partnership itself realizes gross income.”48 For Cunningham, the only relevant question is whether the partnership interest was received for services performed in the past or in the future. Property received for services already per-formed ought to be taxed currently, regardless of whether the prop-erty is styled as a profits interest or a capital interest. If property is re-ceived in exchange for future services, however, current taxation would violate realization principles, and a wait-and-see approach is proper. Embedded in Cunningham’s argument, however, is the as-sumption that subchapter K was arguably intended to encourage

46 Cunningham, supra note 11, at 256. As an example, Cunningham discusses a partnership that holds a single asset, a ten year bond with a face amount of $1000 bearing interest at the rate of 10% a year. The partnership hires a service partner, S, who receives (1) a 25% interest in both the profits and capital of the partnership, (2) a 65% interest in the partnership capital, but no profits interest, and (3) a 40% profits interest, but no capital. In each case, the current fair value of S’s interest is 25%. Yet the tax consequences differ markedly. This result, she ar-gues, “ignores the economic reality that any given interest in a partnership is composed of some percentage of the partnership’s capital and the return on capital, or profits.” Separating the two conceptually, she continues, is a mistake. “The disaggregation of these components of the interest does not change the fact that each represents a significant portion of the value of the partnership’s assets.” Taxing one while not taxing the other, she concludes, has no apparent justification.

47 See Cunningham, supra note 11, at 260 (“Where the profits interest is granted in anticipa-tion of services to be rendered in the future, … taxation of the interest on receipt would violate the realization requirement and the policy against taxing human capital. This would be incon-sistent with the basic purpose and structure of subchapter K.”)

48 Cunningham would therefore limit immediate taxation to cases in which the service partner completed all or substantially all of the services to be rendered at the time it receives its interest in the partnership.

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“just this type of pooling of labor and capital[.]” It depends what type of pooling “this” type refers to. Congress contemplated the pooling of labor and capital among small business professionals. But Cunning-ham does not address the workings of these rules in the large invest-ment fund context. Today, perhaps two or three trillion dollars in in-vestment capital is flowing through private investment partnerships, with the income derived from managing that capital largely deferred until realization. It’s not clear that Congress would make the same choice if asked to consider it on these terms. Taxing the value of self-created assets. To examine the ques-tion more closely, it is useful to assume for the moment, as tax schol-ars normally do, that the tax liability of partners should generally be determined by treating the partnership as an aggregate of individuals, rather than as an entity. Aggregate treatment generally dictates that an individual be taxed identically whether the business is operated in partnership form or as a sole proprietorship.49 The next question is whether, in a sole proprietorship, one would be taxed on an unrealized increase in wealth attributable to one’s own labor. The answer, under current law, is no: One is gener-ally not taxed on unrealized imputed income in the form of self-created assets.50 If you build a gazebo in your backyard, you are not taxed when the last nail is struck. You are only taxed, if at all, when you sell the house. If you rent a kiosk at the mall and stock it with appreciated works of art, you are not taxed when you open for busi-ness. You are only taxed as you realize profits from selling the paint-ings.

Should this tax treatment be extended from the individual to the partnership context? The policy rationale in extending the Code’s generous treatment of self-created assets to partnerships may derive from a desire to be neutral between a service provider’s decision to act as a sole proprietor or provide services within a partnership. Tax-ing a service partner currently would appear to distort the choice be-tween becoming a partner versus a sole proprietor engaging in a bor-

49 See Cunningham, supra note 11, at 260-61. 50 See Mark P. Gergen, Reforming Subchapter K: Compensating Service Partners, 48 Tax. L.

Rev. 68, 79 (1992); but cf. Noel Cunningham & Deborah H. Schenk, How to Tax the House that Jack Built, 43 TAX L. REV. 447 (1988) (arguing for accrual taxation when a taxpayer uses capital on its own behalf).

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rowing transaction.51 Professor Rudnick, following this train of thought, argues for deferral. She acknowledges that the analogy is imperfect; some projects are too risky to be funded entirely with debt. In that case, she argues, pointing to restricted stock (coupled with an § 83(b) election) as the classic example, “the tax law has generally al-lowed service providers to share equity returns with others and to re-ceive capital gain returns.”52

A subtle yet important detail, however, distinguishes the taxa-tion of a partnership profits interest from restricted stock. When valuing restricted stock for purposes of a § 83(b) election, the relevant regulations do not allow one to rely on liquidation value alone. In the context of high-tech start-ups, for example, the rule of thumb among Silicon Valley practitioners is that even in the case of common stock with no liquidation value, the common stock should be valued at least at one-tenth the value of the preferred stock to reflect the option value of the common stock. This approximation is generally thought to be low, and these valuations have been receiving increased scrutiny as a result of § 409A. But even at a low valuation, current practice with respect to restricted stock results in some immediate recognition of in-come, while partnership profits interests, under current law and the proposed regulations, may be valued at their liquidation value or zero. There is, in other words, an inconsistency between the treatment of partnership and corporate equity that Professor Rudnick does not fo-cus on. Still, Professor Rudnick is right in that the tax Code tends not to tax the imputed income from self-created assets. Professor Len Schmolka, along similar lines, argues that just as one should not be taxed on the creation of self-created assets until realization occurs in a market transaction, neither should one be taxed on the creation of partnership-created assets. One should be taxed only on the income that those assets actually generate in market transactions.53

Professor Schmolka suggests that we need only ask one ques-tion: Were the services rendered in one’s capacity as a partner? If one acts as a partner (and not as an employee or independent contrac-

51 Rudnick, supra note 38, at 354. 52 Rudnick, supra note 38, at 355 & n.528. 53 See Schmolka, supra note 16, at 294.

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tor) then one ought to be allowed to enjoy the benefits of Subchapter K. He explains that the “same policy of tax neutrality that apparently animated the contribution and distribution rules” should bar recogni-tion by partners, “provided they join as partners” and not as mere employees or independent contractors.”54 If one insists on recognizing the economic value of a profits in-terest, Professor Schmolka argues, the proper economic analogy is to § 7872, which governs compensation-related and other below-market interest rate loans. Professor Cunningham’s central premise is that a naked profits interest shifts the use of capital for an indefinite period to the service partner. “Economically,” Professor Schmolka notes, “that temporary [capital] shift is the equivalent of an interest-free, compensatory demand loan.” The service partner is compensated through the use of the other partners’ money. Section 7872 principles ought to apply. Section 7872 would force service partners to recog-nize ordinary income for the forgone interest payments on the deemed loan; if the deemed loan had an indefinite maturity, then the rules would demand this interest payment on an annual basis so long as the “loan” remained outstanding. Subchapter K normally comes close to this result by looking to actual partnership income (the income pro-duced by the constructive loan) rather than using a market interest rate for lack of a better proxy. So long as the service partner’s ser-vices are rendered as a partner and not as an employee, Professor Schmolka concludes, nothing beyond subchapter K is needed. Professor Schmolka’s argument holds up, however, only if the partnership is one that has current income from business operations, like a law firm or a restaurant. The income of the partnership is not a good proxy for the ordinary income of a service partner if, as is the case in venture capital and private equity funds, the realization doc-trine defers the partnership’s recognition of income for several years. (The partnership’s timing of income is determined at the entity level, when it liquidates portfolio companies. Even with an increase in

54 See Schmolka, supra note 16, at 297 (emphasis in original). Schmolka stresses that the tax law draws distinctions analogous to the capital/profits interest distinction all the time, when-ever it draws a line between property and income from property. For example, the transfer of a term interest in property yields different tax consequences than transferring a remainder inter-est. See Schmolka, supra note 16, at 289. The coupon stripping rules of section 1286, he asserts, “mark the only instance of congressional abandonment of this judicially developed distinction between property and income from property.” See Schmolka, supra note 16, at 291 n.20.

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wealth, there is no income to allocate to the partners until investments are liquidated.) In sum, the tax treatment of a partnership profits interest pro-vides deferral benefits that go beyond what one might achieve with an economically equivalent transaction (a nonrecourse loan from the LPs to the GP, followed by an investment of the proceeds in a capital interest in the partnership). Professor Schmolka’s observation that such deferral benefits are consistent with subchapter K principles is accurate, but besides the point: these principles are in tension with other aspects of the tax Code (such as §§ 83 and 7872) that argue for taxing human capital in an economically accurate manner. Ulti-mately, the correct approach depends on the extent to which we want to allow the flexibility and favorable tax treatment of subchapter K to override other tax policy considerations. Professors Cunningham, Schmolka, Rudnick and Gergen all raise valid concerns about the measurement of unrealized income; I address these concerns next.

C. Measurement Concerns

The strongest argument for deferral is the difficulty of measur-

ing a partner’s income on an accrual basis. This argument is espe-cially strong in the context of venture capital and private equity funds, where the underlying investments are illiquid. A mark-to-market system could not function, as there is no market for portfolio companies from which we could reliably estimate a value.55

Cost-of-capital method. The valuation problem may not be as intractable as it seems. While neither a mark-to-market nor mark-to-model system is desirable, we could use another proxy, which I call the “cost-of-capital” method. The GP would have imputed income, on an annual basis, of an interest rate times its share of the profits

55 Under certain assumptions, deferral is a red herring. So long as tax rates are constant and the employer and employee are taxed at the same rate, deferral is irrelevant, as the increase in income also gives rise to greater tax on that income later on. In this context, however, the tax rates are not equivalent, assuming a capital gains preference. The compensation (if one chooses to view it as such) should be taxed at 35%, but because the character of the income is deter-mined at the partnership level, the earnings are often taxed at the long-term capital gains rate of 15%. One could characterize this as a conversion problem, but the opportunity arises only because we allow the income to be deferred in the first place.

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times the amount of capital under management. For ease of explica-tion, in the text that follows I assume an interest rate of 8%; the ap-propriate rate would actually have to be indexed to the applicable federal rate. I derive this method from Professor Schmolka’s analogy to a nonrecourse loan. The usual move is to analogize a 20% profits inter-est in a partnership to an at-the-money call option on 20% of the fund. But a profits interest is also economically equivalent to a non-recourse, zero stated interest rate demand loan of 20% of the capital under management, where the GP invests the loan proceeds in the fund. The GP effectively borrows 20% of the contributed capital from the LPs, but it is not asked to pay interest on the loan. Under the principles of § 7872, as the imputed interest is forgiven each year, that amount should be treated as ordinary income. The principles of § 7872 provide a convenient proxy for the GP’s unrealized income. Example. To illustrate, imagine a $100 million fund that ap-preciates to $150 million over three years. The GP would receive $10 million, or 20% of the $50 million in profits. Now, imagine that in-stead of a 20% profits interest, the LPs made the GP a $20 million loan. The loan is made non-recourse on the condition that the loan proceeds are invested in the fund. The fund appreciates to $150 mil-lion, making the GP’s share worth $30 million. The GP then pays back the $20 million, leaving it with $10 million, the same as if it had received the profits interest in the first place. The twist is that the GP never pays any interest on the loan. Under § 7872, the GP would have to annually recognize, as ordinary income, the amount of the loan times the short-term applicable federal rate of interest. By struc-turing the transaction as a profits interest, the GP escapes the tax con-sequences of § 7872. 56

56 The cost-of-capital method gets considerably more complicated if one assumes that the GP should receive a basis adjustment in its capital interest to reflect the deemed interest payments to the LPs. If the imputed loan is characterized as a loan from the LPs, however, rather than an imputed loan from the partnership, it is clear that no basis adjustment is required. If you borrow money to make an investment, and pay interest on the loan, your interest payments are not added to the cost basis of your investment. The fact that the loan comes from other inves-tors does not change the analysis.

There is the further sticky question of whether the GPs should receive a deduction for the im-puted interest payments. Because there are no loan proceeds to trace to the purchase of prop-erty, it is difficult to apply the usual tax rules. Professor Schmolka argues that the fact that there are no actual loan proceeds, the default assumption that loan proceeds are used for per-

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It may be helpful to back up a step. The deferral problem is caused by the realization doctrine, which reflects the fact that we can-not reasonably estimate the value of the partnership’s assets on an annual basis. The key challenge is disaggregating the relative value of the returns on human capital, which we would presumably like to tax currently as the services are performed, from the returns on in-vestment capital, which we would like to tax only when the income is realized. We cannot measure the returns on human capital directly; under current law, if the compensation is paid in the form of a profits interest, we estimate the return on human capital portion at zero and treat the entire amount, if and when it is received, as a return on in-vestment capital. I argue here that there is another proxy available. It is an imperfect proxy, and it’s likely to undervalue the true amount of the increase in value of partnership assets that reflects a return on human capital, but it is undoubtedly more economically accurate than current law, which estimates this amount at zero. We can estimate the return on capital by using the amount of capital contributed to the pool, combined with contract agreed to between the GP and its inves-tors, to reasonably estimate the value of the contribution of labor based on the opportunity cost to investors. In sum, in circumstances where a partnership’s income is de-ferred by reason of the realization doctrine, current law allows defer-ral of returns on human capital. A cost-of-capital method might prove to be a better measurement of income than current law, thus ensuring that taxpayer’s choice of form is driven by economic consid-erations rather than tax considerations. The cost is added complexity; current law works well in most contexts outside of investment part-nerships.

sonal consumption ought to apply, making the interest non-deductible. See Schmolka, supra note 16, at 312 n.105. I find it more persuasive to note that the right tax policy here is to deny the deduction on the grounds that the loan proceeds are used to purchase or carry tax-advantaged property. Since § 7872 is used here only as an analogy, we need to struggle to fit into one of the § 163 boxes. We may simply specify the cost-of-capital method as a special charge to the GP which does not give rise to a basis adjustment.

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IV. CONVERSION

I now shift focus from the timing of income from a partner-ship profits interest to the character of that income once recognized. Most tax scholars agree that if we are going to tax labor income di-rectly (rather than consumption), we ought to tax labor income at pro-gressive rates.57 A flat, lower rate on capital income can be justified because of lock-in effects and other considerations, and a rich debate surrounds the capital gains preference. But generally speaking our tax system tries to tax labor income at progressive rates, and by and large it succeeds. One largely overlooked anomaly in the system is the treatment of sweat equity. Sweat equity, as I define it here, is the abil-ity to invest with pre-tax dollars in one’s own business.58

Sweat equity is more lightly taxed than other forms of labor

income. The entrepreneurial risk subsidy that results can be justified on both administrative grounds and, perhaps, on the widely-shared view that entrepreneurship generates positive social externalities. As I explain below, however, what is surprising about sweat equity is that the subsidy for entrepreneurship does not stem primarily from the capital gains preference. Rather, it comes from the inability to tax the imputed income that accompanies working for oneself – the abil-ity to invest with pre-tax dollars. Doing away with the capital gains preference for sweat equity, therefore, would not extinguish the en-trepreneurial risk subsidy.

57 For that matter, most consumption tax advocates, at least in academic circles, prefer a pro-gressive system. An exception to the general consensus in favor of progressivity can be derived from optimal income tax theory, which suggests an efficiency rationale for declining or flat marginal rates. See James Mirrlees, An Exploration in the Theory of Optimum Income Taxa-tion, 38 REV. ECON. STUD. 175, 207 (1971).

58 There are four departures from a pure endowment tax base that create potential tax bene-fits: (1) the ability to choose to work for oneself at a lower salary than one might be able to make in the market (the self-investment with “pre-tax” dollars); (2) deferral on the receipt on the op-tion value of “sweat equity,” (3) deferral as the equity value appreciates, and (4) on exit, the op-portunity to be taxed at capital gains rates on the labor income which has been converted into a self-created capital asset. The last three are departures from a Haig-Simons income tax base. Only the fourth departs from an ideal consumption tax base (and only by reason of the low rate of tax). One way to think about sweat equity, then, is as a self-help consumption tax for entre-preneurs.

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A. Below-Market Salary and Conversion

Imagine a grocer who could earn $50,000 a year managing the

produce section of a branch of Whole Foods, a natural and organic foods retailer. Instead, he borrows money, uses the money to open a local organic grocery, and pays himself a modest salary of $20,000 per year. Ultimately, he pays off the debt and sells the store to a financial buyer three years later for a large gain. Under endowment tax princi-ples, the grocer should be taxed at ordinary income rates on $50,000 per year, followed by a recontribution of the $30,000 difference be-tween a market rate of salary and his actual salary (the human capital now converted into investment capital) back into the business. Any additional gain or loss would be properly treated as capital gain or loss. But because we resist the concept of endowment taxation (and the second-guessing of one’s choice of employment), we have no easy way of seriously questioning whether the amount of salary the grocer pays to himself is an improper base for taxing his labor. His invest-ment in his own business is treated as a true investment, and the character of that gain is respected as such.

In many cases, even if we believe the current salary is too low,

the difference is inconsequential. If the grocery store generates cur-rent operating income, the income will either pass through to the gro-cer (if the business is organized as a sole proprietorship, partnership, or S Corporation) or will be taxed at the entity level (if organized as a C Corporation). Even if the grocery’s appreciation in value is de-ferred – say, if it derives from the increase in value of the underlying land on which the store sits – the grocer won’t necessarily benefit. While his current income is artificially low, so too is his basis in the grocery store. When the store is sold, the income will be captured by the greater difference between the amount realized and the grocer’s adjusted basis. Assuming constant tax rates, the deferral would be ir-relevant from a tax policy standpoint.

The model just described breaks down in two ways, however,

revealing the subsidy for entrepreneurship. The first is in the assump-tion of constant tax rates. When the grocery store is sold, the gain or

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loss may be treated as long-term capital gain.59 Thus, if one is work-ing for oneself, so long as one is willing to put up with the entrepre-neurial risk of taking a below market salary and investing in the busi-ness, the tax code provides a subsidy in the form of conversion from ordinary income to capital gain. Professors Ron Gilson and David Schizer have noted how, in an analogous situation, the tax law subsi-dizes the founders of venture capital-backed start-ups in the same way, allowing them to place low tax valuations on their common stock.60

The second way the model breaks down is its failure to tax the

imputed income that comes from investing in a self-created asset. In more familiar terms, the service partner has the ability to invest in his own business using pre-tax dollars. As we shall see, it is the failure to reach this imputed income that provides the bulk of the subsidy.

B. Compensating Service Partners

Let us focus first on the model’s first assumption of constant

tax rates. We could address this problem by treating sweat equity as labor income. We could treat all income that arises from the labor of

59 I am assuming, for the sake of simplicity, that the increase in value comes from gain that would be capital in nature, such as an increase in the value of the underlying land, rather than gain that would be ordinary, such as gains attributable to unrealized receivables or inventory.

60 See Ronald J. Gilson & David M. Schizer, Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock, 116 HARV. L. REV. 874 (2003). See also Jesse M. Fried & Mira Ganor, Agency Costs of Venture Capitalist Control in Startups, 81 NYU L. REV. 967 (2006). Section 409A has complicated matters somewhat, as aggressive valuations could be questioned by the government and subjected to an excise tax. Unlike other scholars, however, I would characterize the problem as not simply one of valuation, but rather a problem that is inextricably tied in to the fact that the portfolio company’s value depends on the efforts of the entrepreneur. Even if one had a crystal ball about market conditions, regulatory risk, and all other exogenous factors that could affect the price of the stock, the valuation would be imper-fect unless one also could assess the talent, preferences, and ability of the entrepreneur.

It is useful to identify this valuation problem as one of valuing “entrepreneurial risk” rather than market risk. Unsystematic market risk can be hedged with the use of financial capital through diversification or other techniques. Entrepreneurial risk, on the other hand, can be hedged only through the contribution of human capital. The analysis is fundamentally the same in the context of partnership profits as in the case of the portfolio company. The liquida-tion value of the profits interest is zero. The option value is high, but only because the partner is talented and will put the money to work. Congress has shown a willingness to limit conver-sion opportunities in the context of the partnership tax rules, such as in § 751 (which forces exit-ing partners to recognize their share of ordinary income assets held by the partnership, like in-ventory). I am indebted to Professor Steve Bank for this point about § 751.

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service partners as ordinary income, full stop. This approach would treat the grant of a profits interest in a partnership as an open transac-tion; as income is received, however, it retains it character as ordinary income.61 Professor Mark Gergen, in a 1992 Tax Law Review article, outlines the necessary reforms.62

Professor Gergen’s approach is relatively simple. It does not change the status quo with respect to realization. A grant of a profits interest in a partnership, in and of itself, would not give rise to taxable income. When compensatory allocations are made, however, they would be treated as salary paid by the partnership. The allocation would be income to the recipient and the partnership would deduct or capitalize the expense.

Professor Gergen argues that the decision not to tax the ex-

change of a profits interest for services “arguably compels” taxing al-locations of profits as compensation. Otherwise, he argues, partners enjoy “extraordinary privileges” not available to service providers in other contexts. If the partnership’s income is not service-based, the service partners do not pay social security tax. They never pay tax at ordinary rates if the allocations represent capital gain, or if they sell their profits interest to a third party or sell it back to the partnership. If they receive in-kind compensation, they may pay no tax at all.

Professor Gergen acknowledges that the measurement of in-

come is imperfect. But it is the best that we can do, he argues, absent some form of accrual taxation. “These changes measure the income of service partners and other partners,” he explains, “as well as it can be measured given the current rules on deferred compensation and capi-talization outside of subchapter K.” Importantly, the proposal would not discourage innovative compensation arrangements. By making the tax consequences follow the economics more closely, however, the proposal would reduce distortions between the use of corporate equity and partnership equity.

61 See Henry Ordower, Taxing Service Partners to Achieve Horizontal Equity, 46 TAX LAW-

YER 19 (1992). 62 See Gergen, Compensating Service Partners, supra note 50.

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C. The Entrepreneurial Risk Subsidy

Surprisingly, Professor Gergen’s approach does not eliminate

the tax advantage associated with a profits interest in a partnership. Specifically, it fails to capture address the second failure – the failure to tax the imputed income from investing labor in one’s own business. To illustrate, let us return to the example of the grocer.

Example 1 (Whole Foods). Suppose that the grocer only

needs $13,000 per year to live on. He could work for Whole Foods and get paid $50,000 per year. Assume a flat 35% tax rate on ordi-nary income. If he works for Whole Foods, he would have $32,500 after-tax, and after spending $13,000 on living expenses, he would have $19,500 left to invest. He invests that $19,500 in Google stock, which doubles in value in one year to $39,000. He then pays tax at the long-term capital gains rate of 15%, leaving him with after-tax in-vestment proceeds of $36,075.

Example 2 (Crunchy LP – current law). Now imagine that in-

stead of working for Whole Foods, the grocer starts his own natural foods store, Crunchy LP. He becomes the GP of Crunchy. Assume that an investor contributes $300,000 to the partnership.63 The grocer receives a 20% profits interest, and Crunchy pays him a salary of $20,000, which leaves him $13,000 (after tax) to live on. Assume that the grocery store doubles in value to $600,000 and is liquidated; the grocer receives 20% of the profits, or $60,000. He then pays tax at 15%, leaving him with after-tax investment proceeds of $51,000.

Example 3. (Crunchy LP – Gergen approach). Under Ger-

gen’s approach, all the facts remain the same as in example 2, but the grocer now pays income tax at ordinary income rates of 35%, creating a tax liability of $21,000 ($60,000 times 35%), leaving him with after-tax investment proceeds of $39,000.

63 The assumption of $300,000 is based on industry practice. In the corporate context, the op-tion value of common stock with no liquidation value is often assumed to be one-tenth the value of the preferred stock. The grocer’s interest, then, would be worth $30,000, which repre-sents the difference between what he could have made at Whole Foods ($50,000) and the salary he makes at Crunchy.

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It is somewhat counter-intuitive that the grocer is better off in

this example, paying tax on proceeds from his investment in Crunchy at 35%, than he was in example one, where he paid tax on his invest-ment in Google at a 15% rate. The key is that, notwithstanding the higher tax rate upon realization, under Gergen’s approach the entre-preneur is still permitted to invest in his own business using pre-tax dollars.

Example 4 (Surtax approach). To reach parity and fully

eliminate the imputed income / entrepreneurial risk subsidy, we would have take the result from the Gergen approach ($39,000) and impose an additional surtax equal to the long-term capital gains rate (15%) times $19,500 (VF to check this amount – see Halperin article), which imposes an additional tax liability of $2,925, leaving the grocer with after-tax proceeds of $36,075.

Example 5 (Crunchy LP - Nonrecourse loan). Gergen’s ap-

proach would also permit some planning opportunities. Now assume that, rather than a partnership, the grocer borrows $60,000 at 8% from the LP investor on a non-recourse basis, and he uses that $60,000 to purchase a 20% capital interest in the partnership. When the investment doubles in value and the partnership is liquidated, at what rate should the grocer pay tax? On the one hand, the grocer provided services to the partnership. On the other hand, the grocer invested capital in the partnership, which normally gives rise to capi-tal gain or loss, not ordinary income. Unless one recharacterizes the loan somehow, capital gains treatment seems appropriate.

Assuming the capital interests are respected as such, the grocer

receives liquidation proceeds of $120,000. Interest on the loan comes due, but the interest is forgiven, giving rise to a liability under § 7872 of $1,680. The basis of the capital interest would be $60,000, leaving taxable income of $60,000. That amount would be taxed at 15%, cre-ating a tax liability of $9,000. After repaying the loan ($60,000), the grocer would have left after-tax proceeds of $48,320, ($60,000 less $9,000 capital gains less $1,680 § 7872 liability), assuming that the im-puted interest payment is non-deductible.

Example 6 (Crunchy LP – cost of capital method). Return

again to the facts of example two, where the grocer takes a salary of $20,000 to cover his living expenses and receives a profits interest of

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20%. The cost-of-capital method I outlined above supplies a useful method for approaching economically accurate results. Assume that investors could have expected an eight percent return on other in-vestments, and so we will use that amount as the cost of capital. The grocer would pay a tax of 8% (cost of capital) times 20% (profits inter-est) times $300,000 times 35%, or $1,680, on his imputed income from the use of the LP’s capital. The amount realized on liquidation would be $60,000; the adjusted basis is zero. That amount would then be subject to long-term capital gains rate of 15%, leaving him with a tax liability of $9,000. This amount realized of $60,000, less the cost-of-capital tax paid ($1680), less the capital gains paid ($9,000) again leaves the grocer with after tax proceeds of $48,320.

Summary of Examples

Example Fact Pattern Tax Law Option After-Tax Income

Whole Foods Market salary + in-vesting after-tax in-come

Current Law $36,075

Crunchy Below-market salary + profits interest

Current Law $51,000

Crunchy Below-market salary + profits interest

Gergen $39,000

Crunchy Below-market salary + profits interest

Surtax $36,075

Crunchy Below-market salary + profits interest

Cost-of-Capital Method

$48,320

Crunchy Below-market salary + non-recourse loan to buy capital interest

Current Law $48,320

Two subtle factors embedded in tax policy drive the variation in results. The first factor is the failure to tax the imputed income that comes from working for oneself. It follows directly from our unwill-ingness to tax endowment or – to put it more gently – our unwilling-ness to tax unrealized gains from human capital. We allow the grocer

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to turn down the job at Whole Foods and invest in his own business using what are, in endowment tax terms, pre-tax dollars. As a result, the grocer is always better off investing in his own business than working for someone else and investing in an equally valuable busi-ness. It reflects the preference that results from converting one’s labor income into investment capital. The only way to eliminate the sub-sidy would be to treat all returns from human capital as ordinary in-come and to impose another surtax at the long-term capital gains rate. Few tax scholars and even fewer politicians would have the stomach for that approach.

The second factor is that current law assumes, under certain circumstances but not others, that the financial capital is costless to supply. The financial capital – whether in the form of a loan to the grocer, or the capital contribution of LPs in the fund context – is diffi-cult to value in the hands of the residual equity holder. Current law takes a variety of approaches, depending on the form in which the capital is provided (debt, partnership capital interests, preferred stock, etc.). One approach we may want to consider is to approximate its value by looking at the opportunity cost to the supplier of the finan-cial capital. If the lender or limited partner had deployed the capital elsewhere, what return would it have achieved? Using some estimate of the cost of capital achieves more economically true results than cur-rent law, which ignores the cost of capital in the partnership profits interest context.

In sum, the ability to convert labor income into investment in-

come creates a powerful tax subsidy for taking on entrepreneurial risk. The subsidy, however, goes beyond the capital gains preference, and, short of establishing an endowment tax, probably could not be eliminated from the tax system even if we were so inclined. In the next section, I overview the reform alternatives that follow from this analysis.

V. REFORM ALTERNATIVES

An entrepreneurial risk subsidy of some sort probably makes sense as a matter of tax policy. The economics literature suggests that there are positive externalities associated with entrepreneurship. The case for an entrepreneurial tax subsidy is more complicated than one

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might think, however.64 Growth companies that succeed create posi-tive spillover benefits to the economy, but for every successful com-pany there are also failures, which may impose social costs. Many small businesses, for that matter, do not create new jobs, but merely displace old ones. A progressive tax system, by its very nature, pro-vides some insurance against risk by compressing the distribution of after-tax incomes.65 And, as noted in the previous section, the income tax embeds a valuable subsidy in its structure by failing to tax the un-realized human capital invested in one’s own business. As a practical matter, then, some tax subsidy for entrepreneurship will continue in any regime short of an endowment tax. The case for a tax subsidy that goes beyond this built-in advantage for “sweat equity” is certainly plausible, but it has yet to be made. Furthermore, it’s difficult to transport the entrepreneurship arguments beyond venture capital and into the broader world of private equity partnerships, which tradi-tionally tend to invest in slow growth companies.

Making the normative case for (or against) such a subsidy is

beyond the scope of this Article. The best tax design for the taxation of partnership profits depends not only on one’s preference for an en-trepreneurship subsidy, but also on a dizzying number of other tricky assumptions, including:

o one’s views about distributive justice,

o the role of the tax system in redistributing income,

o whether we take the entity-level tax of publicly-traded corpo-rations as a given,

o whether we take the tax-exempt status of pension funds and endowments as a given,

o whether we take the capital gain preference as a given, and at what rates, and with what holding period,

o whether we take the realization doctrine as a given,

64 See generally Douglas Holtz-Eakin, Should Small Businesses Be Tax-Favored?, 48 NAT’L

TAX J. 387 (1995); William M. Gentry & R. Glenn Hubbard, Tax Policy and Entrepreneurial Entry, AMER. ECON. REV. 283 (2000); Donald Bruce & Tami Gurley-Calvez, Federal Tax Pol-icy and Small Business (March 2006 manuscript on file with the author).

65 See Evsey D. Domar & Richard A. Musgrave, Proportional Income Taxation and Risk-Taking, 58 Q. J. ECON. 388 (1944).

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o what we predict the incidence of the tax subsidy to be (i.e.,

how much of the tax benefit to fund managers is passed on to other parties, such as the founders, employees, and customers of the portfolio companies they fund)

o the efficiency and dynamic revenue effects of the increased in-centive, on the margins, for fund managers to relocate over-seas.

Given the number of variables and the uncertain economic effects of various changes, the indeterminacy of the normative case is daunting. Realistically, then, the decision of whether and how to reform the partnership tax rules and/or subsidize private equity may be a politi-cal question best decided with heuristics. And so, rather than advo-cate a particular normative viewpoint, this Article identifies a range of possible reform options and the likely tax policy benefits and draw-backs of the various options.

I offer six alternatives below: (1) the status quo, which allows

both deferral and conversion, (2) the Gergen approach, which allows deferral but no conversion, (3) the forced valuation approach, (4) the cost-of-capital method, which eliminates deferral but allows some conversion, (5) the true preferred variation on the cost-of-capital method, which allows deferral and conversion only under certain cir-cumstances, and (6) the talent-revealing election, which allows defer-ral and conversion only under certain circumstances.

A. The Status Quo

Under current law, a profits interest is not taxable upon re-ceipt, and income may be deferred until realization at the partnership level, and converted into capital gain. The status quo has the benefit of being predictable and well-understood by practitioners.

Some social policy effects of the status quo are unclear. Cur-rent law provides a sizable, categorical subsidy for the private equity industry. This tax subsidy probably lowers the cost of capital for ven-ture capital-backed startups, which might be good economic policy; the status quo also benefits private equity more broadly, certain hedge funds, and disadvantages innovation ventures at publicly-held corpo-rations. If the social policy goal is to encourage innovation, more tar-geted incentive structures ought to be considered.

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A few drawbacks of the status quo, however, are crystal clear. Current law encourages regulatory gamesmanship and leads to wasteful tax planning. It distorts the design of the contract between GPs and their investors, increasing agency costs. And it circumvents our system of progressive tax rates, which undermines widely-held principles of distributive justice. The status quo has one added benefit, which is that the gamesmanship that we see is a known quantity. Changing the treat-ment of a profits interest in a partnership would create new pressures on the system. For example, funds might replace profits interests with options to acquire a capital interest, which is economically equivalent. The taxation of compensatory partnership options is not entirely settled law, and any of the reform options discussed below would probably have to be extended to reach compensatory partner-ship options as well. Similarly, new funds will have an increased incentive to locate overseas. To the extent that frictions require the performance of ser-vices in the United States, however, this concern may be overstated. Funds that target U.S. portfolio companies rarely perform those ser-vices from abroad; indeed funds show a remarkable tendency to con-gregate regionally [VF to expand – esp. re London].

B. The Gergen Approach

The simplest reform approach is derived from Professor Ger-

gen. The receipt of a profits interest in a partnership would be treated as an open transaction. When distributions are ultimately made to the profits partner, however, the distributions would be treated as or-dinary income, regardless of the character of the underlying assets sold by the partnership.

The benefit of this approach is its relative simplicity. One

could implement a rule that any property received in exchange for services is, once realized, treated as ordinary income. This approach has the benefit of treating partnership equity in the same way that we treat its closest corporate cousin, a nonqualified stock option.

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The Gergen approach would not eliminate the subsidy associ-

ated with the ability to invest with pretax dollars. This aspect of his approach is consistent with the broader entrepreneurial risk subsidy of the Code, embedded in many aspects of the tax treatment of sweat equity. Gergen’s proposal is consistent with nonqualified stock op-tions. If consistency with corporate equity is important, then Ger-gen’s approach is a sensible compromise.

A drawback of the Gergen approach is the availability of

planning options. For example, a GP could secure a non-recourse loan for 20% of the capital of the fund and use the proceeds to buy a capital interest in the fund. Forgone interest on the imputed loan would be taxed pursuant to § 7872, but some deferral and conversion could still be achieved.

Arguably, the Gergen approach overtaxes the general partner.

To the extent that the GP’s investment in the fund is subject to mar-ket risk, treating the investment in the fund as ordinary income dis-advantages that investment compared to other investments the GP might make. The cost-of-capital method, discussed below, presents an alternative method that matches up more closely with the econom-ics of the deal.

C. The Forced Valuation Approach

Another alternative would be to revisit the holding of Dia-

mond, which established that only the receipt of a partnership interest with determinable market value gives rise to immediate taxable in-come. This approach would reduce deferral but allow some conver-sion into capital gain.

The idea would be to force the round peg of partnership eq-

uity into the square hole of § 83.66 In the corporate context, if an en-trepreneur joining a new start-up receives common stock and a ven-ture capital fund holds preferred stock, the receipt of the common stock still gives rise to taxable income. The stock may not be valued simply by taking the liquidation value of the stock, which is typically

66 It is the habit of most tax professionals to depict partnerships as ovals or circles and corpo-rations as squares or rectangles.

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zero. Rather, the valuation must also account for the option value of the common stock. The problem, of course, is that given the specula-tive nature of the enterprise, an appraisal necessarily resorts to rules of thumb, is easily gamed, and will tend to understate the option value of the interest. Moreover, § 409A forces appraisers to take the ques-tion more seriously than before, driving up administrative costs, but generating little in the way of revenue. There is little reason to believe that forcing valuation of partnership profits interests in this fashion would lead to a different result.

D. The Cost-of-Capital Approach

A cost-of-capital approach would, like the forced valuation approach, reduce deferral but allow some conversion into capital gain. Counter-intuitively, it provides a greater entrepreneurial risk subsidy than the Gergen approach, and it provides precious few planning or gamesmanship opportunities.

Under a cost-of-capital approach to taxing a profits interest in

a partnership, fund managers would be allocated an annual cost-of-capital charge as ordinary income. The allocation would be equal to a market rate of interest times the percentage profits interest times the amount of capital under management. The GP’s use of the LPs’ capital is like a compensatory loan; but for the services provided by the GP, the LPs would charge a market rate of interest on the loan.67 The true market interest rate would be rather high, given the non-recourse nature of the “loan” and the level of risk involved. Because the actual cost-of-capital is difficult to know, however, I propose fol-lowing § 7872’s approach and deeming a normal rate of interest to have been forgiven.68

This approach results in a modified form of accrual taxation. The GP would be taxed currently on the value of the use of the LPs’

67 [elaborate on the choice of interest rate. AFR is low. Arguably, because the investment is risky, the interest rate should be high. But I’m just looking for rough justice here, and it would be tough to estimate the risk of different funds, and then police that estimate.]

68 The cost-of-capital approach could be extended to other contexts, such as to estimate the option value of common stock. Detailed consideration of such an application is beyond the scope of this project.

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capital. To the extent the fund appreciates, however, those gains would not be recognized until the income is realized by the partner-ship. The character of any gains would be preserved as capital gains.69 The benefit of the cost-of-capital approach is the balance it strikes between recognizing the compensatory aspects of a partner-ship profits interest as ordinary income, while still offering a signifi-cant entrepreneurial risk subsidy. Importantly, it would be more dif-ficult to plan around without altering the underlying economic ar-rangement between the GP and the LPs. Compared to current law, it would represent a move towards neutrality of tax form that would both reduce agency costs and the deadweight loss associated with tax planning. This approach reduces the incentive to unduly favor part-nership profits interests over other, economically equivalent forms of compensation, thus reducing economic distortions in contract design and minimizing planning opportunities. It is, however, rather com-plex. It might be difficult for taxpayers and the IRS to administer. An added benefit of the cost-of-capital method is its effect on hedge fund managers. Many hedge fund managers would be unaf-fected by a change in how we treat the character of carried interest distributions; many hedge funds generate ordinary income and short-term capital gain. Under a cost of capital method, these managers would also be taxed on their use of the proceeds of the imputed loan from the LPs. Such tax treatment is appropriate, even absent conver-sion into capital gain, as it reflects the option value of the partnership equity.

69 Basic Example. Suppose LPs contribute $95 million to a private equity fund, and the GP contributes $5 million. The GP also receives a two percent annual management fee and twenty percent carried interest. Assume for the sake of simplicity that all the capital is contributed at once and is invested in portfolio companies. In Year One, the GP would take two million dol-lars in management fees. Because the management fees are not contingent, they would be taxed under 707(c) as if the GP were an employee, just as they are now. The GP would be taxed $2 million as ordinary income, and the partners would allocate the deduction according to the terms of the partnership agreement. Next, we account for the cost of capital. Assume a market interest rate of 6%. Under a cost-of-capital approach, the GP would pay a cost-of-capital surtax in the amount of $532,000 (8% cost of capital times 20% profits interest times $95 million (the non-GP source of capital) times a 35% tax rate). This amount would be ordinary income to the GP. The LPs would be allocated a $532,000 deduction according to their per-centage interests as reflected in their capital accounts (or would capitalize the expense, as ap-propriate). Any realized gains or losses from the fund’s operations would be allocated as usual.

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E. True Preferred Return Variation

The next alternative is a “true preferred return” variation,

which would allow full deferral and conversion for profits interests that reflect the cost-of-capital. This approach would allow taxpayers to achieve both the deferral and conversion available under current law, but only for profits interests that are effectively indexed to reflect the investors’ cost of capital. Fund managers would do this by offer-ing investors a return on capital plus a true preferred return before sharing in any additional profits. If the contract is designed so that investors receive back all of their capital plus a fee that reflects the cost of capital or time value of money before fund managers share in the profits, then no current ordinary income charge would be as-sessed, and any additional proceeds allocated to the fund managers would be eligible for capital gains treatment (to the extent appropriate under current law).70

The intuition here is that the profits interest is still like a loan

from the investors to the fund managers, but this time the loan has adequate stated interest, and so the form of the original economic ar-rangement may be respected as such for tax purposes. A true pre-ferred return ensures that the profits interest reflects true economic profits, and not just the time value of money. Accordingly, if a fund has a true preferred return, the cost-of-capital approach would not apply, and deferral is available.71 Allowing a safe harbor for carried interests subject to a preferred return also has potentially positive corporate governance effects.72 Under current industry practice, true preferred returns are unusual. Instead, most funds use a hurdle rate. Once the GP realizes a gain that allows the fund to clear the hurdle, the hurdle disappears,

70 Few investors require managers to pay a true preferred return before sharing in profits; the current tax rules, which favor partnership equity over management fees, may help explain why. See Fleischer, The Missing Preferred Return, supra note 4, at xx.

71 Cf. Schmolka, supra note 16, at 311 n.100. The intuition is that, to the extent the GP clears a preferred return, it is achieving the sort of abnormal return that we associate with equity risk, not the predictable return we associate with debt. To be sure, the GP is still receiving some-thing of value, as the non-recourse nature of the “loan” means that the GP is taking its invest-ment risks with other people’s money. In my view, however, limiting the deferral to abnormal returns is consistent with our tax system.

72 The goal here is not to force the use of a preferred return, but rather to remove the usual tax disincentive to using one. See Fleischer, The Missing Preferred Return, supra note 4.

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and the GP is then allocated a disproportionate amount of future gains until it has received carry as if it received 20% on a first dollar basis. In the case of a hurdle rate, the “preferred return safe harbor” would not apply. The situation is analogous to a debt instrument without adequate stated interest under § 7872 or the OID rules.73

F. Talent-Revealing Election

The last approach is a “talent-revealing election,” which would change the default rule to the Gergen approach but allow partnerships to elect into the cost-of-capital approach. Similar to a § 83(b) election for restricted stock, the election would be attractive to managers who expect to achieve greater investment returns and unat-tractive to managers who aren’t so sure. It would accelerate current income but would allow conversion of any additional income into capital gain. By allowing managers to choose between deferral and conversion, the election might serve as a useful screening device, re-vealing useful information to investors.

The election is consistent with our tax system’s usual method

of handling executive compensation valuation problems. We offer executives a choice. Generally, if property is not vested, the executive may elect to be taxed currently, and the fair value (less any amount paid) becomes taxable as ordinary income, and any further apprecia-tion is eligible for the capital gains preference. The valuation is per-formed as if the property were not subject to vesting requirements or other restrictions. If no election is made, the full amount is taxable as ordinary income if and when the property vests.

I recognize that the analogy to restricted stock is a little off; the

closest economic analogy is to a nonqualified stock option, and under § 83(e)(3) one cannot make an 83(b) election with respect to an option with no readily ascertainable fair market value. Here, however, the cost-of-capital method is used to approximate the compensatory value of the use of someone else’s capital, and it thus serves as an appropri-ate amount for inclusion under a § 83-style election. Section 83 reflects

73 [need to consider analogy to contingent debt instruments? PFIC rules?]

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a policy of having a default rule that property (and gains from prop-erty) received in exchange for services is ordinary income unless the property recipient elects out of deferral to get the reward of conver-sion if things go well.

Gergen’s approach, then, could become our default rule. Compensatory allocations would be ordinary income in the usual case. Partners could then elect in to the cost-of-capital approach, which would accelerate income but offer the promise of capital gains on appreciation.

G. Summary

Any of these alternatives would bring unwelcome attention to a widely-exploited tax subsidy. Naturally, Congress may anticipate some opposition from industries that use partnerships, such as the real estate industry, the oil and gas industry, the timber industry, and the small business community in general. Congress may want to consider a “rifleshot” anti-abuse approach, carefully targeting any reform to reach only large, private investment funds. By limiting its application to large investment partnerships,74 lawmakers could balance con-cerns of efficiency, fairness, and progressivity with concerns about administrative convenience and political viability. The talent-revealing election has the special attraction of pursing both sensible tax policy and governance goals.

74 Depending on how narrow policymakers intend the approach to be, the rules could apply only to partnerships where capital is a “material income producing factor,” cf. § 704(e)(1), or even just to “investment partnerships” defined as investment companies for purposes of the In-vestment Company Act of 1940 but for application of the 3(c)(1) or 3(c)(7) exemptions, similar to the definition in § 743(e)(6) of the Code.

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VI. CONCLUSION

This Article’s most novel contribution, a cost-of-capital ap-

proach to valuing partnership profits interests, might seem rather complicated. But it really just amounts to a rough justice tax treat-ment of an economic arrangement with lengthy historical roots.

According to Silicon Valley lore, in the “old” days (the 1950s

and 1960s) VCs would make investments on a deal-by-deal basis. Today, VCs raise capital for a fund which makes ten or twenty port-folio company investments. But in the old days it was one at a time. A VC would find a promising start-up and ask investors to put money in. As compensation, the investors would loan the VC enough money to invest alongside, and interest on the loan would be forgiven. The investors were said to “carry” the investment of the VC, since they bore the cost of capital, and the VC could simply walk away from the non-recourse loan if things didn’t work out for the portfolio company. This arrangement, which is economically equivalent to a profits inter-est in a partnership, is where the term “carried interest” came from.

Under current law, of course, the forgiven interest would give

rise to current income to the VC. (Section 7872, which dictates this result, was not passed until 1969.) Despite the apparent complexity, the economics of the arrangement have deep historical roots—indeed, according to Professor Michael Weisbach, roots that go back as far as 13th century Venetian merchants. The problem of taxing this ar-rangement isn’t going away, and while the solutions are complex, the modern day boom in private equity finance has raised the stakes. It is time for tax policy analysts to reconsider the puzzle.

[check this – is the origin from oil and gas – working inter-

est vs. carried interest?]

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