Carried Interest Revisited: Bullseye on its back

The New York Times in their Business section today published an informative article on “carried interest” and private equity. As could be expected this tax planning and financing technique is again on the radar screen for elimination due to a variety of factors, including the odorous lust of revenue by liberals, notions of tax fairness and a few other factors. Industries affected by a change are gearng up. The link to the piece can be found at:

http://dealbook.nytimes.com/2013/01/21/with-tax-advantages-looking-shaky-private-equity-seeks-a-new-path/

Carried interests are a business and financial arrangement that have been and form an essential structural element to almost every section of the U.S. economy including, real estate development, private equity, hedge funds, health care, mining, and oil and gas. Changes in the tax rules would have a profound impact on how these businesses operate and their structure

I have written on this subject several times. I thought it would be interesting to see portions of one of the articles, which shows how the subject is much broader than just some “fund manager” making more dough than the rest of us. This was done in 2011. Here is a shorten version: 

The Democrats are bent on raising taxes. Everyone knows that.  The list is long, the gimmicks plentiful and if you move the wrong way, you are in the sights to be taxed more. However, it was interesting to note Democratic leaders are again targeting repeal or at least a substantial modification of a “carried interest”, despite repeated failures to eliminate it in recent years. The concept has been in the President’s budget for some time and passed the Democrat-controlled House in the last Congress. 

 Goodness, what can that be? “Carried” what? Who is “Carrying” whom? Carried interests are a business and financial arrangement that form an essential element of business in almost every section of the U.S. economy (including, real estate, private equity, hedge funds, health care, and oil and gas.) See, there are those oil and gas boys in the sights again. Changes in the tax rules would have a profound impact. 

In brief, the tax treatment of carried interests allows managers of hedge funds, private-equity funds, venture-capital funds and others to pay a lower 15% income tax rate applied to investment income as capital gains, rather than higher income tax rates.

How do they do that? It is complicated and requires by starting with taxation of partnerships. If you have an interest in a partnership, you are allocated a share of that partnership's income.  The income to the owner takes on the same character, such as capital gains, that it does in the partnership's hands, and the partner is taxed on it accordingly. Some investment partnerships, particularly in the private equity industry, earn mostly capital gains by buying and selling shares in other companies.  The managers of these companies thus receive their carried interest in the form of capital gains and pay capital gains tax rather than ordinary income tax. 

What many policymakers object to is the fact the carried interest paid to partnership managers is really compensation for their management services.

It is hard to have crocodile tears for the hedge fund managers. However, there are other industries where the carried interest is engrained and useful. No one knows how any revisions, if included in the debt deal, will affect these other sectors but it is useful to examine to see how they work by showing an example involving the old whipping boy of oil and gas.

In oil and gas development (and in most extraction industries) the term "carried interest" refers to an arrangement where one co-owner of an operating interest (the " carrying party") incurs an obligation to pay all of the cost to develop and operate a mineral property, in exchange for a right to recoup this investment out of the proceeds from the first production. After the investment is repaid, any subsequent production is divided between the other co-owners. The co-owner, not obligated to pay for the development and operation, holds a “carried interest” in the mineral property until the carrying party's initial investment is repaid. There are many different types of carried interests, the details varying considerably from arrangement to arrangement.

A simple example is as follows:

Jack owns all the working interest in an oil and gas lease and wants to drill a well but cannot afford it. Jack assigns to Big Oil the entire interest in the property, and Big Oil agrees to drill and complete a well bearing all the costs. Big Oil will retain 100 percent of the working interest until it recovers its entire costs (drilling, completing, equipping, and operating the well) from the proceeds (or “runs” as they are called) of the production. After cost recovery, a percentage of the working interest in the property goes back to Jack with each party owning a share.

As far as tax treatment, Jack realizes no gain or loss on the transfer of the property even though drilling a productive well only increases the value of the property interest returned to Jack. Jack has a basis equal to his basis prior to transfer. Jack cannot deduct any of the cost incurred.

Jack can receive his share of production income and report it as such, or he can sell his interest as a capital asset. In this simple example, there is no tax partnership arrangement, which can change the tax treatment. However, the point being, this is a long-standing arrangement that serves a legitimate purpose. Big Oil helped Jack finance the drilling of his well which otherwise would not have occurred. Jack intends to take a well-deserved vacation.

The question being, how will this be changed if the carried interested is changed, decimated or otherwise hammered? Will the policymakers make an exception or is any thing fair game in getting at oil and gas. I Carried interests are a business and financial arrangement that have been and form an essential structural element to almost every section of the U.S. economy including, real estate development, private equity, hedge funds, health care, mining, and oil and gas. Changes in the tax rules would have a profound impact on how these businesses operate and their structure.

I can understand the reasoning against the equity firms that are also providing management services to earn their carried interest but I do not see the tax abuse for Jack in our example. 

Changes in the taxation of carried interests have passed a Democrat-controlled House of Representative three times since 2007 and the Obama Administration has included a carried interest tax increase in each of its annual federal budgets where the current law on carried interests was described as “an unfair and inefficient tax preference.”

 

Of course, the tax rate for capital gains has been increased reducing its benefit, but that is not enough for some. If tax reform goes forward this year, the carried interest is a likely target for major changes.