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Abstract: The capital structures of venture capital-backed U.S. companies share a remarkable commonality: overwhelmingly, venture capitalists make their investments through convertible preferred stock. Not surprisingly, a large part of the academic literature on venture capital has sought to explain this peculiar pattern. Financial economists have developed models showing, for example, that convertible securities allocate control depending on the portfolio company's success, operate as a signal to overcome various kinds of information asymmetry, and align the incentives of entrepreneurs and venture capital investors. In this Article we extend this literature by examining the influence of a more mundane factor, tax law, on venture capital structure. A firm that issues convertible preferred stock to venture capitalists is able to offer more favorable tax treatment for incentive compensation paid to the entrepreneur and other portfolio company employees: Instead of being taxed currently at ordinary income rates, the entrepreneur and employees can defer tax until the incentive compensation is sold (or even longer), at which point a preferential tax rate is available. No tax rule explicitly connects the employee's tax treatment with the issuance of convertible preferred stock to venture capitalists. Rather, this link is part of tax "practice" - the plumbing of tax law, familiar to practitioners but, predictably, opaque to those, including financial economists, outside the day-to-day tax practice. Despite its obscurity, this tax factor is likely to be of first order importance. Intense incentive compensation for portfolio company founders and employees is a fundamental feature of venture capital contracting. Favorable tax treatment for this compensation is a byproduct and, we believe, a core purpose of the use of convertible preferred stock. We also highlight an important but low visibility tax subsidy for the venture capital market, and the early stage, usually high technology, firms that are financed there. Although this subsidy arose inadvertently, it has an interesting structure. Funds are not provided directly to companies selected by the government (a familiar technique outside the United States), or to all companies. Instead, venture capital investors are enlisted as the subsidy's gatekeeper. As a practical matter, only companies that can attract venture capital investment receive this subsidy. Our analysis thus adds a different twist on the familiar debate about providing subsidies through the tax system, instead of through direct expenditures or favorable regulatory treatment.
Abstract: In the capital markets, the 1990s have been the decade of executive stock options and the derivatives market. Legal scholars and economists have begun to realize that, in combination, these two trends raise a serious concern. Options are supposed to inspire better performance by tying pay to the stock price. Yet, what if an executive could use the derivatives market to simulate a sale of her option -- a practice known as "hedging" -- without violating her contract with the firm? The incentive justification for option grants would no longer hold. This Article demonstrates that the tax law helps avert this consequence in the United States; this phenomenon, in turn, shows that the U.S. tax law performs an important corporate governance function, not previously recognized in the academic literature. The tax law discourages executives from hedging options (but not necessarily from hedging stock holdings, although such hedging raises somewhat different concerns). Whereas shareholders and executives should contract to ban options hedging, the existing tax barrier is a plausible substitute. Indeed, since the tax law already has reason to monitor and penalize hedging, it can perform this corporate governance function without significant new administrative costs. Yet the tax barrier is overbroad and potentially unstable. Indeed, it could unravel due to relatively minor changes in the tax law that seem far removed from corporate governance. Moreover, the tax barrier does not govern foreign executives who are not subject to U.S. tax. Accordingly, this Article recommends strengthening contractual and securities law constraints on hedging. It concludes with reflections about the capacity of tax to influence corporate governance, not only for the worse, as has widely been observed, but also sometimes for the better.
Abstract: In recent years, the government has enacted a series of narrow tax reforms targeting specific planning strategies. Sometimes these reforms stop the targeted planning, but sometimes they merely prompt a new, more wasteful variation. The difference often lies in so-called frictions, which are constraints on tax planning other than the tax law, such as fees, accounting or regulatory treatment, credit risk, and the like. While frictions are important, reformers often lack key information, and legal academics should help provide it. This Article offers general observations about frictions that deter end runs. Most promising are strong "discontinuous" frictions that impose significant costs when taxpayers depart, even in subtle ways, from the transaction covered by the reform. Costs of relying on frictions are also considered, including information costs and distributional effects. Two case studies also are offered involving tax-motivated use of derivative financial securities. These reforms use essentially the same statutory language, but taxpayers have responded differently - and frictions explain this difference. The first reform, the "constructive sale" rule of Section 1259, targets use of derivatives in effect to sell an appreciated asset without paying tax. The second, the "constructive ownership" rule of Section 1260, targets use of derivatives in effect to invest in a hedge fund (or other pass-through entity) without the usual adverse tax consequences (i.e., less deferral and a higher tax rate). Theoretically, taxpayers can avoid either rule through relatively modest changes in the derivative's economic return. This strategy is commonly used to avoid Section 1259, a reality that was understood by government and taxpayers alike when the measure was enacted. In contrast, this strategy is not commonly used to avoid Section 1260. The difference, which was not well understood by Section 1260's drafters, is that securities dealers cannot supply the derivative that theoretically avoids the rule.
Frictions; Tax planning; Section 1259; Section 1260
Abstract: Although short sales make an important contribution to financial markets, this transaction faces legal constraints that do not govern long positions. In evaluating these constraints, other commentators, who are virtually all economists, have not focused rigorously enough on the precise contours of current law. Some short sale constraints are mischaracterized, while others are omitted entirely. Likewise, the existing literature neglects many strategies in which well advised investors circumvent these constraints; this avoidance may reduce the impact of short sale constraints on market prices, but may contribute to social waste in other ways. To fill these gaps in the literature, this paper offers a careful look at current law and draws three conclusions. First, short sales play a valuable role in the financial markets; while there may be plausible reasons to regulate short sales - most notably, concerns about market manipulation and panics - current law is very poorly tailored to these goals. Second, investor self-help can ease some of the harm from this poor tailoring, but at a cost. Third, relatively straightforward reforms can eliminate the need for self-help while accommodating legitimate regulatory goals. In making these points, we focus primarily on a burden that other commentators have neglected: profits from short sales generally are ineligible for the reduced tax rate on long-term capital gains, even if the short sale is in place for more than one year.
Short Sales, Speculative Bubble, Tax, Capital Gain, Locate Requirement, Uptick Rule, Noise Trader
Abstract: Complex "derivative" financial instruments are often used in aggressive tax planning. In response, the government has implemented mark-to-market type reforms, but only partially. Considered in isolation, these incremental reforms are likely to seem well advised in measuring income more accurately. However, there is an important "second best" cost, emphasized in this Article: the ability of well-advised taxpayers either to avoid the new rule or to turn it to their advantage (here called "defensive" and "offensive" planning options, respectively). This Article uses two case studies to identify how these effects arise and to suggest ways of combating them. The first case study, Section 475, requires securities dealers to use mark-to-market accounting. Although this rule curtails tax planning by securities dealers themselves, it enables dealers to serve as accommodation parties for their clients' tax planning: Once exempted from generally applicable rules, dealers can offer clients a tax benefit (e.g., accelerated losses) without experiencing a corresponding tax cost (e.g., accelerated income). The second case study, the contingent debt regulations, requires lenders and borrowers to report pre-realization gains and losses based on assumed annual returns. Although this reform seems to accelerate the lender's interest income, the rule's narrow scope allows tax-sensitive lenders to avoid this result. Accordingly, the new rule is likely to apply only when tax-exempt entities lend to tax-sensitive borrowers, who enjoy the regulations' accelerated interest deductions. This Article offers ways to remedy these reforms, as well as general guidance about how to implement incremental mark-to-market reforms without exacerbating the planning option.
Abstract: By now, it is well understood that aggressive tax planning among high-income individuals and corporations represents a grave threat to the U.S. tax system, and that derivatives are staples of this planning. In response, the usual recommendation is consistency, which means that the same tax treatment should apply to economically comparable bets, regardless of what form is used. Yet because consistency is unattainable, this Article develops an alternative theory: Policymakers should strive instead for balance. This means that for each risky position, the treatment of gains should match the treatment of losses. For example, if the government bears 15% of losses, it has to share in 15% of gains. On a different derivative, if the government bears 35% of losses, it should share in 35% of gains. As long as this matching is achieved across the board for all risky bets, the admittedly counterintuitive reality is that taxpayers need not prefer, or engage in planning to attain, a low effective rate. A low rate obviously is appealing for gains, but it is correspondingly unappealing for losses (i.e., since deducting the loss is less valuable). Moreover, even if a low rate is desired, taxpayers can get the same aftertax return by increasing the size of their bet. The main advantage of this reform agenda is flexibility. To prove this point, this Article outlines three ways to match gains and losses on derivatives: mark-to-market accounting; a novel reform called the stated-term approach, in which gains and losses are deferred until the scheduled maturity date of the derivative, even if the contract is terminated earlier; and a zero tax rate. The provocative conclusion is that these thoroughly inconsistent approaches can coexist for economically comparable derivatives, without prompting planning. Yet this flexibility is not free, so the limitations of this reform agenda are considered as well, along with implications for cutting edge problems in the taxation of derivatives, including the timing and character rules for swaps, Section 1032, and the wash sale rules.
Abstract: Loss limitations are an ugly but inevitable feature of any realization-based income tax. In essence, because the system mismeasures gains, it also has to mismeasure losses. Otherwise, the "timing option" inherent in the realization rule would allow taxpayers to defer gains (thereby reducing the tax's present value) while accelerating losses (thereby preserving the deduction's present value). The wash sale regime of Section 1091 is one of our system's most important brakes on the timing option. In broad outline, this regime defers a taxpayer's deduction when she sells a position at a loss and, within a specified period of time, acquires an economically similar position. Yet the wash sale regime is quite old, and the recent bear market has further exposed its frailty. Indeed, it is only a slight exaggeration to say that compliance with the regime is voluntary for very wealthy taxpayers - or, at least, for those who are willing to take aggressive positions. In response, this article flags seven glitches in the regime that, at least arguably, permit "perfect end runs." This article also takes a more controversial position: Losses should still be deferred - even when taxpayers make meaningful changes in their economic position - as long as they keep material elements of their old return. This article offers two justifications for this broad loss deferral. First, under the "parity" goal, it should be difficult to accelerate losses because it is so easy, under current law, to defer gains. Put another way, since modest economic changes do not trigger gains, they should not trigger losses either. Second, under the "effectiveness" goal, the regime should be sufficiently tough that taxpayers actually give up on tax-motivated loss harvesting, instead of merely pursuing this planning in a more sophisticated way.
Abstract: Loss limitations are an ugly but inevitable feature of any realization-based income tax. In essence, because the system mismeasures gains, it also has to mismeasure losses. Otherwise, the timing option inherent in the realization rule would allow taxpayers to defer gains (thereby reducing the tax's present value) while accelerating losses (thereby preserving the deduction's present value). The wash sale regime of Section 1091 is one of our system's most important brakes on the timing option. Yet it is only a slight exaggeration to say that compliance with the regime is voluntary for very wealthy taxpayers - or, at least, for those who are willing to take aggressive positions. In response, this Article flags seven glitches in the regime that, at least arguably, permit perfect end runs. As used here, this phrase refers to strategies in which taxpayers can deduct losses while effecting virtually no change in their economic position. The essential point is that, if we are going to have a wash sale regime, these end runs should not be allowed. This Article also takes a more controversial position: Losses should still be deferred - even when taxpayers make meaningful changes in their economic position - as long as they keep material elements of their old return. The policy goal here is to ensure that, on average, taxpayers expect losses to be deferred as long as gains. This Article proposes concrete modifications in the regime to implement this goal, while also offering a caveat: The case for a strong wash sale regime is less strong if the regime can never be tough enough to stop loss harvesting. If so, other constraints on the timing option may be preferable, including accelerated timing for gains or a broader capital loss regime.
Abstract: Indexed stock option grants reward executives for outperforming a benchmark, such as the market as a whole or competitors in the same industry. These options offer superior incentives by diminishing the influence of factors beyond an executive's control, such as general market and industry conditions. Yet indexed options are almost never used. Professor Saul Levmore seeks to explain this puzzle with norms. The main point of this comment on his Article is that tax plays a larger role in this puzzle than Professor Levmore acknowledges, although tax is not a complete explanation. The tax appeal of traditional options is that they offer value that is not really performance-based (i.e., a bet on the market as a whole), but nevertheless is treated as "performance based" under Section 162(m) - and thus is deductible without limitation. Accounting and Professor Levmore's norms-based account are then briefly considered.
Indexed options, tax, Section 162(m), accounting
Abstract: The charitable deduction has enjoyed relatively little support in the legal academy. Many commentators have asked what it adds to the tax system and, as critics have observed, the deduction obviously does not itself collect tax revenue. Defenders respond that the deduction helps measure income and keeps taxpayers from inefficiently substituting leisure for work, but these points are, of course, contested. Instead of revisiting debates about what the deduction adds to the tax system, this Article focuses on the broader question of what it adds to the pursuit of public goals. The deduction - and any other government subsidy that matches charitable contributions through the tax system (here called "subsidized charity") - enlists private individuals to pursue public goals in a somewhat unique manner. While in other settings the government delegates implementation but still specifies the goal to be pursued, charitable donors are allowed to select the goal as well. Is it desirable to pursue public goals in this way? This Article analyzes three reasons to subsidize charitable contributions, each responding to a different information or incentive problem that is inherent in the pursuit of public goals. First, the subsidy can counter free-riding by encouraging donors to be more generous. A second objective is to measure and respond to popular preferences about public goals. Subsidized charity can encourage experimentation and competition and can empower minority perspectives that are underrepresented in the political process. Yet subsidized charity also disproportionately represents the views of wealthy donors. The third goal, which is new to the academic literature, is to recruit private donors to monitor the quality of nonprofits, so that the government can piggyback on these quality-control efforts. Since there are three competing rationales for the subsidy, its institutional design can vary depending upon which has priority - an insight that is new to the literature. To encourage generosity, the subsidy should focus on wealthy donors, giving them broad discretion about which causes to support and targeting marginal contributions. Recruiting these wealthy donors as monitors is largely compatible with this program. Yet by focusing on wealthy donors, the subsidy may fail to reflect broad popular preferences. In response, one option is to compensate with other policy instruments, such as government programs, to address the preferences of low-income nondonors. While I find this approach appealing, others could reasonably want subsidized charity itself to be more representative. Toward that end, we can go to extra lengths to persuade low income taxpayers to contribute more (e.g., through extra-generous matches) or, for that matter, to induce wealthy donors to contribute less (e.g., through caps on giving) or to support causes that reflect broad popular consensus (e.g., through limits on which causes are subsidized). Yet the cost of making the subsidy more representative in this way is that it will be less effective at advancing our other goals of encouraging generosity and recruiting monitors.
Abstract: Tax shelters and aggressive planning derive in part from a structural imbalance in our tax system that has not been adequately explored: In important respects, the private tax bar outmatches their counterparts in government. Although a strong policy case can be made for remedying this mismatch, this Article emphasizes two institutional barriers that complicate any solution, rooted in the political economy of taxation and the economics and professional norms of the legal profession. First, although it would be enormously helpful to dramatically increase the staffing levels and pay of government tax administrators, this is a politically daunting task. Second, a fallback strategy is to look to the private bar for help, but they face a significant conflict. Both market pressure and professional norms motivate them to serve their clients, who generally do not have an interest in improving government tax enforcement. In light of these two challenges, what can be done to mitigate the mismatch between the government and private bar? This Article offers two sets of proposals. First, a number of suggestions focus on the government, offering ways to improve recruiting and reinforce the expertise at their disposal without dramatically increasing funding or raising pay substantially across the board. For example, the government should focus on recruiting senior lawyers out of retirement (whose financial demands will be limited) and having them mentor junior lawyers directly from law school (whose private sector pay is high, but not nearly as high as it will become in later years). The government should also consider a loan forgiveness program for these recent graduates, and should also enlist academics to assist with discrete projects. The government should also retain private law firms to litigate tax controversies with extraordinary precedential value. Second, this Article offers guidance about the right way (and the wrong way) to tap the expertise and information possessed by the private bar. It is more effective, whenever possible, to ask lawyers to help the government in a way that also helps their clients. Using this principle, this Article identifies promising opportunities that have been overlooked, and critiques unpromising initiatives that have attracted significant government support. For example, clients do not want their own tax deals shut down, but they feel differently about their competitor's deals, so the government should make more systematic use of this opportunity. Likewise, although clients are less motivated to help the government identify bad transactions that are inadvertently permitted, they are highly motivated to identify good transactions that are inadvertently prohibited. As a result, the government can look to the private bar for help in narrowing overbroad anti-abuse measures. On the other hand, in asking tax advisors to disclose their clients' aggressive transactions - in effect, to "rat" on their clients - the government is asking for something that clearly is not in the clients' interest. This reality is likely to undercut this initiative, which has been one of the centerpieces of the government's efforts to date.
Abstract: To encourage pay for performance, Congress offers certain tax advantages when stock options are used as compensation. Yet these advantages arguably are not available to so-called "indexed" options, which reward executives for good relative performance (i.e., instead of absolute increases in stock price). The tax costs of indexed options are as ironic as they are unintended. The relevant tax rules are supposed to favor performance-based pay and, if anything, indexed options are more performance-based than conventional options. As a result, these tax rules should be reformed. While portions of this Article originally appeared in David M. Schizer, Tax Constraints on Indexed Options, 149 U. PA. L. REV. (2001), this Article is substantially different. Most importantly, this Article explains why some practitioners believe indexed options cannot qualify as performance-based pay under Section 162(m), and thus cannot be deducted in excess of $1 million. This Article offers a legal interpretation that allows a deduction, and suggests that the tax authorities are likely to offer a favorable ruling on this issue.
Abstract: The high level of petroleum consumption in the United States contributes to environmental harms, burdens national security, and increases urban sprawl and traffic congestion. In response, the Obama administration has proposed targeted subsidies and regulatory mandates. We do not believe this will be an effective strategy because Congress has no comparative advantage in picking technological winners and losers. Among serious policy analysts, there is consensus that the best approach is to increase prices through a gas tax. The problem, however, is intense and widespread public opposition to this approach. We propose an alternative that offers many important benefits of a gas tax but is more politically palatable, and also will not reduce aggregate consumer demand: a revenue-neutral petroleum fuel price stabilization plan (the “PFPS”). The essential idea is to set a floor under the price of gasoline. If the market price falls below this threshold, then consumers would pay an additional levy on petroleum fuels to make up the difference. For example, suppose the PFSP sets a floor of $3.50 per gallon. If the price would otherwise fall to $3.00, the PFPS contribution would raise the price by 50 cents. But if the market price rises to $3.75, the levy would be zero. Our goal is not to collect revenue, but to influence behavior. Accordingly, we propose that any revenues collected be fully refunded to consumers pro rata. While consumers as a group would experience no net decline in purchasing power, individuals would, of course, be affected: those who consume less than the average amount of gasoline would enjoy a net benefit, while those who consume more would incur a net cost. Thus, the PFPS would create a systematic long-term incentive to reduce petroleum fuel consumption with a neutral fiscal impact. Our proposal would signal to consumers, auto manufacturers, and investors in alternative energy technology that petroleum fuel prices will not decline below the floor price in the future. Armed with this information, consumers, manufacturers and energy investors would commit to making fundamental changes in their behavior and their investments in new technology – without need of targeted government subsidies – because they would know that their investments would not be undermined by a future collapse in petroleum prices. Such assurances are crucial, as recent events have shown. Without a stabilization program, the wild fluctuation in oil prices in 2008 will leave investors and consumers all the more wary of investing in energy efficiency. Our proposal also has significant political advantages. The fact that it is refundable means that those who consume the average amount of petroleum or less will make net profit from the program, and thus will become a constituency for it. Moreover, if the floor on gas prices is set below the level of gas prices when the program is enacted – something that is easy to do when prices are high – then voters could take comfort in the fact that they would never have to make any payments under the program as long as oil prices do not decline. Of course, if the price floor is set at a low level, the program would have less impact. This is apt to be the case if the plan is adopted at a time when gas prices are low, and the price floor is kept at a level below the market price. In response, a range of adjustments to our proposal are possible.
Abstract: As financial engineering becomes more sophisticated, taxing income from capital becomes increasingly difficult. We offer the first empirical study of a high profile strategy known as "tax-free hedging," which offers economic benefits of a sale without triggering tax. We explore nontax costs that taxpayers face when hedging by issuing so-called "DECS," "PHONES," and other publicly-traded exchangeable securities. Focusing on 61 transactions between 1993 and 2001, we shed light on why taxpayers might prefer to hedge through private "over-the-counter" transactions: An offering of exchangeable securities is announced in advance and implemented all at once, triggering an almost 5 percent decline in the underlying stock price before the hedge is implemented.
DECS, frictions, constructive sales, hedging, capital gains
Abstract: As financial engineering becomes more sophisticated, taxing income from capital becomes increasingly difficult. A crucial issue for tax policy makers, then, is the case - or difficulty - of implementing tax-advantaged transactions. We offer the first empirical study of a high profile strategy known as "tax-free hedging," which offers economic benefits of a sale without triggering tax. We explore one method of hedging, in which the taxpayer issues publicly-traded exchangeable securities, known by acronyms such as DECS and PHONES. We focus on such offerings between 1993 and 2001, identifying 61 transactions that account for $24 billion in proceeds. Using these publicly-available data, we offer empirical evidence about various frictions that might discourage taxpayers from hedging with exchangeable securities. In so doing, we shed light on why taxpayers might prefer to hedge through private "over-the-counter" transaction with derivatives dealers. The main reason is that an offering of exchangeable securities is announced in advance and implemented all at once, triggering an almost five percent decline in the underlying stock price before the hedge is implemented.
Abstract: As financial engineering becomes more sophisticated, taxing income from capital becomes increasingly difficult. A crucial issue for tax policymakers, then, is the ease - or difficulty of - implementing tax-advantaged transactions We offer the first empirical study of a high profile strategy known as 'tax-free hedging,' which offers economic benefits of a sale without triggering tax. We explore one method of hedging, in which the taxpayer issues publicly-traded exchangeable securities, known by acronyms such as DECS and PHONES. We focus on such offerings between 1992 and 2001, identifying 61 transactions that account for $24 billion in proceeds. Using these publicly-available data, we offer empirical evidence about various frictions that might discourage taxpayers from hedging with exchangeable securities. In so doing, we shed light on why taxpayers might prefer to hedge through private 'over-the-counter' transactions with derivatives dealers. The main reason is that an offering of exchangeable securities is announced in advance and implemented all at once, triggering an almost four percent decline in the underlying stock price before the hedge is implemented.
Abstract: Perhaps no concept in tax law is so well established, and yet so widely criticized, as realization, the rule that defers tax on appreciated property until it is sold. In this Article, Professor Schizer offers a new justification for realization: It is a subsidy for savings. The recent reduction in the capital gains tax rate suggests that Congress wants such a subsidy, the author observes. He then argues that realization has a significant advantage as a subsidy. It is credible, in that taxpayers expect it to survive long enough for them to collect it. This is important, Professor Schizer then argues, because realization offers taxpayers no benefit when an investment is made. It offers only the government's word -- a promise, in essence -- that unrealized appreciation will not be taxed. The author then demonstrates that even though the government remains free to renege on this promise, taxpayers will not expect this for reasons rooted in history, administrability, and politics. Taxpayers thus will have more confidence in realization than in another "promise" subsidy, a low capital gains rate. Notwithstanding this advantage, the author then points out, realization has unique disadvantages, such as the tendency to lock investors into particular investments, and also shares efficiency and equity concerns common to all savings subsidies.
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