Did anyone else notice the elephant in the living room
Last month, Dave Camp, the chairman of the House Ways and Means Committee, released a draft proposal to change how we tax certain types of businesses known as pass-throughs. Under current law, the owners of these partnerships, limited liability companies and subchapter S corporations pay their share of the company’s income or loss on their individual tax returns instead of paying tax at the entity level. Mr. Camp’s proposal would maintain this basic approach and simplify aspects of it for small businesses.
Reaction to Mr. Camp’s proposal has been subdued compared with the praise for his plan to change the way we tax derivatives. Mr. Camp’s willingness to float draft proposals and invite comment should again be commended. But the likely outcome here is a slight change, not a major overhaul.
Incremental change with a minimum of controversy must be Mr. Camp’s goal. That would explain why he takes the corner wide, steering clear of the most controversial aspect of partnership tax: carried interest. Carried interest refers to the share of partnership profits earned by an investment fund manager, and under current law it is often taxed at low capital gains rates. Critics like myself argue that because carried interest is labor income, not investment income, it ought to be taxed as ordinary income.
Mr. Camp’s proposal includes two options. The first option addresses what we might think of as deferred maintenance â€" cleaning up some corners of the tax code that have been neglected. For example, it would relax the anachronistic eligibility restrictions for subchapter S corporations. For partnerships, the proposal would repeal the confusing rules related to “guaranteed payments.†It would also make some useful changes to the partnership tax rules related to basis adjustments and revise some outdated definitions.
The second option, a more radical one, appears to be a stalking horse. This would replace our existing system with a unified set of rules for pass-throughs. This sounds simple and appealing. Many of the ideas in Option 2 are promising, but they are largely untested and not fully explained in the proposal.
For example, Option 2 would replace the labyrinth of rules for determining whether allocations of income will be respected for tax purposes with a simple rule: the tax consequences should track the economic gains or losses. This sounds great in theory, but it’s hard to implement in a system where Congress likes to single out certain activities for special tax treatment.
The tax rules often allow and even encourage the tax consequences of a deal to diverge from the economics. Examples include depreciation deductions (where tax depreciation is accelerated compared with real economic depreciation), tax credits for low-income housing and clean energy and nonrecourse liabilities (when a loan is secured by an asset instead of the partnership or any of the partners).
Suppose a partnership allocates wind energy tax credits to a limited partner who financed a new project with those tax credits in mind. The tax credits, however, have no effect on the partner’s capital account or economic risk of loss. Would the I.R.S. allow the limited partner to take the tax credits Or would the tax credits be denied because they represent artificial tax losses, not real economic losses
In my view, there’s an additional problem with Mr. Camp’s proposal: its failure to address how the partnership tax rules are now being used, and abused, by large businesses. The partnership tax rules were originally created for small business, so a small number of individuals could work in a business together and mix together labor and capital without having to pay an extra layer of tax. The rules are now used in ways that Congress never intended. Two examples are the erosion of the corporate tax base and the tax treatment of carried interest.
The corporate tax base is eroding because many large businesses are able to avoid the corporate tax rules altogether and choose to be taxed as pass-throughs instead. Bain Capital, the Blackstone Group, the Carlyle Group and other large asset management firms are organized as partnerships, yet take in billions of revenue each year. Energy Products Partners, a publicly traded master limited partnership, has a market capitalization more than $50 billion. The Bechtel Corporation, the largest engineering firm in the United States, is organzed as a subchapter S corporation and pays no entity-level tax.
And the proposal doesn’t contain so much as a whisper about carried interest, the most controversial partnership tax issue in recent years.
Of course, Mr. Camp has pitched the proposal as being about simplification of the tax rules for small business. Avoiding the topic of carried interest is consistent with that message.
But if Mr. Camp wants to raise some revenue to pay for tax changes elsewhere, like a reduction in the corporate tax or a shift to a territorial tax system, he will have to follow the money to where it disappears â€" through loopholes like carried interest and the abuse of the publicly traded partnership rules.
For further reading on the use of the partnership tax rules by large asset managers, see Victor Fleischer, “Taxing Blackstone“, Tax Law Review (2008).
For further reading on pass-through entities and how they fit into the broader legislative agenda regarding business taxes, see Karen Burke, “Passthrough Entities: The Missing Link in Business Tax Reform“.
Victor Fleischer is a professor at the University of Colorado Law School, where he teaches partnership tax, tax policy and deals. Twitter: @vicfleischer
