Fifteen and Thirty Five - Class Warfare in Subchapter K of the Internal Revenue Code: The Taxation of Human Capital Upon the Receipt of a Proprietary Interest in a Business Enterprise
Northwestern University Law School
Virginia Tax Review, Spring 2009
Northwestern Law & Econ Research Paper No. 08-21
Service providers (aka executives) to partnerships and to corporations confront a number of choices as to how their compensatory arrangement may be structured and the tax consequences thereof. In the simplest case, an individual may render services to an enterprise in return for cash payments over the period of service. In this non-equity setting, the issue is straightforward and non-controversial. The service provider is treated as receiving ordinary income for services rendered. The return on his or her expenditure of human capital is taxed at progressive rates.
Once the relationship between the service provider and the enterprise becomes more complicated through the service provider's receipt of an equity interest in the enterprise, the tax treatment of the return becomes more complex. If the service provider receives an equity interest in return for services, the issue of whether the receipt of, and return on, the equity interest is attributable to human capital or invested capital is confronted. A tension arises between conceptualizing the receipt of and return on an equity interest and the economic enhancement which it generates as a return on human capital, generating ordinary income, or as a return on invested capital, which in certain settings may be taxed preferentially as capital gain.
In the corporate context, stock in the corporation may be issued in return for the rendition of future services. It may be transferred outright, i.e., free and clear, or be restricted, i.e., conditioned upon the rendition of services for a fixed period of time. Various tax issues are confronted - when is the income taken into account, what amount is taken into account, what is the character of the income from such receipt, and whether and to what extent its compensatory origin must be segregated from any subsequent appreciation in the equity interest.
Subchapter K raises similar issues in the services-for-equity context regarding partnerships, but the tax consequences arise under a single tax, rather than double tax, regime for the enterprise. However, in the partnership context, three types of equity interests may be utilized for compensatory purposes, i.e., a capital interest with an attendant right to profits, a restricted capital with profits interest, and a pure profits interest.
Critics have recently advocated a change in the tax treatment of the return from a compensatory profits interest in a partnership. They conclude that the current tax treatment of the receipt of and return on such an interest is seriously flawed, violating fundamental principles of tax policy. Unfortunately, such advocacy is limited to a narrow analysis of the results generated by a compensatory receipt of a profits interest and lacks a thorough comparison with, and analysis of, the treatment of the traditional compensatory equity transfers in the two dominant business contexts employed in the United States economy, i.e., partnerships and corporations. This Article provides a broader discussion of compensatory equity transfers (capital interests as well as profits interests) in the partnership context and discusses the similarities and dissimilarities between these compensatory arrangements and those arising in the corporate setting. By doing so, this Article illustrates the erroneous assumption that profits interests derive unique and unfair tax treatment.
The recent assault on the status quo treatment of a profits interest in a partnership has gathered momentum, in large part due to the inflammatory rhetoric which attends the academic commentary and the focus by the media on the economic success of private equity ventures. Bills have been introduced in Congress to mandate that such receipts generate ordinary income, rather than preferential capital gain, to the recipient. To date, none has been enacted. However, with the economic freefall and the Congressional need to generate additional tax revenues, the issue of the proper taxation of a compensatory transfer of a profits interest in a partnership will likely be revisited in the next legislative session.
By focusing on but one of the five traditional types of available equity transfers (a profits interest), most of the academic commentary has confused, rather than clarified, the need for reform. The treatment of the return on human capital and on invested capital has never been as clear or as singular as commentators suggest. The Code, for sound policy reasons, refrains from disentangling the return on human capital from the return on invested capital when the service provider "re-invests" his or her return on human capital in the enterprise by foregoing annual compensation. With regard to profits interests, the role of Section 702(b), which requires that all partners in a partnership, regardless of how they acquired ownership of their interest, characterize the nature of their share of the income at the partnership, not the partner, level, is overlooked. Additionally, compensatory profits interests possess implicit, if not explicit, restrictions on transfer and thus require treatment akin to that accorded restricted capital interests in a partnership and restricted corporate stock. Finally, some of the treatment accorded profits interests is attributable to the fundamental differences between the tax treatment of partnerships (single level of tax) and corporations (double level of tax), which some critics either minimize or ignore.
Accordingly, this Article critiques proposals for change with regard to the suggested modification of the tax treatment of profits interests, in large measure by illustrating the misperception of the current operation of Subchapter K of the Code and enterprise equity compensation as a whole. The entire field of compensatory transfers of equity interests and the allocation of the return therefrom to human capital and/or invested capital is surveyed from a tax policy standpoint. In this broader context, the status quo (subject to an elective defect) from a normative standpoint is equal, or superior, to any of the proposals recently advanced.
Finally, with the misdirected emphasis on the tax treatment of profits interests, the real opportunity for reform of the area is overlooked. The ability to recognize income in the year of receipt of a restricted compensatory equity interest under Section 83(b) permits recipients to minimize the impact of the progressive rates. This treatment is far more inconsistent with the taxation of human capital than is the current tax treatment of compensatory profits interests. As a modest proposal for reform, this Article advances the repeal of Section 83(b) which, if enacted, would constitute significantly broader reform than recent proposals and would result in an overall improvement of the current tax law from a policy standpoint.
Number of Pages in PDF File: 69
Keywords: profits interests, carried interests, partnership taxation, private equity, ordinary income method, forced valuation method, cost of capital method, talent-revealing election, compensatory transfers, conversion, deferral, human capital
JEL Classification: K34
Date posted: November 10, 2008
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