Now it’s time to play “Spot the Flaws” in the Common Sense Tax, proposed by John Goodman and Laurence Kotlikoff. Here’s the quick summary:
It features just two taxes. One is a payroll tax that taxes all labor earnings at a flat 13 percent rate. The other is a personal income tax with a 25 percent tax on household income above $100,000, in the case of married households, and $50,000, in the case of singles.
It’s a bit more complicated than that but not much.
I’ll get the ball rolling. Under the CST there are substantial incentives for high income individuals who are can arrange it to take their income as dividends rather than as labor income. So, for example, a married lawyer at a big law firm earning an income of $500,000 if taken as labor income would pay 13% on the first $100,000 and 38% (13% + 25%) on the remaining $400,000. If he reduces his labor income to, say, $1 a year he would pay $.13 in labor income and 25% of $499,999, a substantial savings. That option isn’t available to ordinary workers who’d pay the 13% on their full earnings plus, of course, an additional 25% on earnings above $100,000. Consequently, the tax would continue to be regressive.
The two additional problems I saw were: (1) Payroll tax to be paid solely by employer. In a weak jobs market, I can think of few poorer ideas. (2) Two-thirds of Americans would pay no tax. This makes the revenue stream pretty volatile. There may be some other implications from a system in which the vast majority are beneficiaries without contribution.
This is just appalling: http://www.cnbc.com/id/101137431 As we all now know, because sam told us, private equity is just a big tax scam…..
Dave – you’ve set up a hypothetical, but I’m not sure a lawyer can do what you suggest, unless they just take a credit to their capital account and cash out upon retirement. I don’t know law firm accounting but I suspect they are pass through entities and the lawyer would probably get dinged for phantom income on the deferred cap acct allocation.
sam was recently pathetically trying to make the case that private equity partners – based upon an agenda driven professor and cash starved IRS looking for politically vulnerable entities – were engaging in a “tax scam” by declining current income in favor of capital gains income. With complete lack of understanding of the underlying economic incentives and blinded by ideology he missed crucial points and was reduced to a version of “oh, yeah!? Well my dad can beat up your dad.”
At least in private equity (I think not in law),
1. Two private parties, limited partners and general partners, can privately negotiate the fee structure of their private business arrangement. The IRS should have no say. Further, there is no Bible, or gun to the head that says that general partners must take a salary just so the IRS can tax them.
2. By deferring current income general partners do not draw capital from the limited partners to enjoy certain income, but rather put income into the future and at risk in the portfolio’s performance. This is the holy grail for limited partners. J-curve reduction and alignment of interest.
3. It is true that the income tax rates differ, but its not free. It comes with risk, benefits to the limited partners and the time value of deferred comp. sam may be a petty person who can’t see any farther than to just “stick it” to private equity guys, but the limited partners, who are the client and the people with money at risk don’t really care about sam’s stunted maturity and personality defects. They have sound economic reasons for this practice. And the IRS and sam-like college professors should have no say either. Its not their money.
The issue to be addressed is, are you guys engaged in a business or trade? If the answer to that is yes, as it was in the Sun Capital decision, then the income you derive from your business ought to be taxed as ordinary income, not capital gains. You can engage in all the name calling you want, but that is the issue. You’re going have to face that.
For folks who don’t know, let me give a short synopsis of the Sun Capital decision (No. 12-2312 SUN CAPITAL PARTNERS III, LP; SUN CAPITAL PARTNERS III QP, LP; SUN CAPITAL PARTNERS IV, LP, Plaintiffs, Appellees, v. NEW ENGLAND TEAMSTERS & TRUCKING INDUSTRY PENSION FUND, Defendant, Third Party Plaintiff, Appellant, SCOTT BRASS HOLDING CORP.; SUN SCOTT BRASS, LLC, Third Party Defendants.)
Sun Capital is a PE firm. Here is crux of the case:
sorry for the lousy formatting
@ Drew, I think Big Law used to form Professional Services Corporations and accomplish what Dave is suggesting by accumulating capital and only distributing income as needed. The Tax Code was changed to tax those corporations 35%. A quick look at the largest Chicago firms, and it looks like they organize as LLPs. One thing that might be odd about many large law firms is some provide substantial compensation to those who “brought the client in.” I wonder if that is considered active or passive, because some people might say its the most important thing for a business and others might say it looks like golfing.
sam
Once again you show yourself incapable of a coherent argument on the subject. The Sun decision has absolutely nothing to do with the tax issue at hand re: deferred fee income/reduced LP capital draw/carry. However, what is hilarious, you don’t even know that by citing Sun you are making the very case for capital gains treatment of the carry: active management as opposed to passive. You are so shallow in understanding you don’t even know you are carrying (heh) the water for the industry. Its not name calling, its just an observation from someone who understands the industry and issues about the commentary from someone who so obviously does not.
I know you want desperately to just make a case, any how, any way for higher taxes on PE. But you chose as your Exhibit A the opposite case. Now THAT’s entertainment!
You have to face that.
PD
Heh, golf is good. Thanks. Since transactional lawyers and PE guys are attached at the hip, and knowing what each does, I’d say that lawyers provide professional services – full stop. So do mutual fund managers. As for the client development, so do salesmen of all types. All sounds like oi to me.
I’ve grown accustomed to the brickbats of those who do not understand the PE business but rather just gaze salaciously at tax dollars and try to invent schemes to get them. But given that active vs passive management is the very crux of the OI vs capgains tax argument for a guy advocating OI to cite Sun makes Laurel and Hardy look like rocket scientists.
@Drew
“But given that active vs passive management is the very crux of the OI vs capgains tax argument for a guy advocating OI to cite Sun makes Laurel and Hardy look like rocket scientists.”
Uh, that’s exactly what the Sun Capital decision was about, active management (vs passive investor) and the characterization of an enterprise as a trade or business. Sun tried to pass itself off as merely passive with regard the Scott Brass. The decision employed the “investment plus’ analysis to reach its conclusion the Sun’s claim of passivity was false. That could have tax consequences, as I’m sure you know, for if a enterprise is characterized as a trade or business, its income can treated as ordinary.
And frankly, from the way you talk around here, telling us ad nauseum about your negotiating prowess, your expertise in evaluating managerial horseflesh, and your general all-round wonderfulness as a businessman — and all this coupled with you patently aggressive personality — it strains credulity to well past the breaking point to suppose that you’re not actively and intimately engaged in the running of your portfolio companies. I mean, can anyone around here imagine you sitting back, buddha-like, simply contemplating the situation with detachment?
Perhaps the characterization of firm as a trade or business would not affect the taxation of the management fee conversion. Supposing, arguendo, that the 1st Circuit’s analytic regime is adopted by the IRS, and a PE firm is characterized as a trade or business, can you explain why the income derived from the management fee conversion would not also be treated as ordinary income?
Finally, “I know you want desperately to just make a case, any how, any way for higher taxes on PE. But you chose as your Exhibit A the opposite case.”
Well, I’m not alone. I’m going to just cite articles and not give the links. Dave’s spam catcher would choke. But you can google these.
Bloomberg BNA, “‘Sun Capital’ Could Affect Both Main Street, Wall Street, Analyst Says”
Pensions&Benefits,”Appellate ruling changes game for private equity”
Bloomberg Law, “Carried Interest Tax Break Risks Being Undercut by Court”
Dealbook, NYTimes, “Sun Capital Court Ruling Threatens Structure of Private Equity”
TaxVox, Steven Rosenthal, “Court of Appeals Finds a Trade or Business: Could this Mean Higher Taxes for Private Equity?”
Tax Notes, Steven Rosenthal, “Private Equity is a Business: Sun Capital and Beyond”
Dealbook, NYTimes, “A Chance to End a Billion-Dollar Tax Break for Private Equity”
Stradley Ronen, Private Equity & Tax Alert, August 2013,
“Sun Capital Decision Could Bring Stormy Times for PE Funds”
Forbes, Tax Analysts, “Sun Capital Might Be Bigger Than You Think”
Etc. There’s more out there if you care to look. And you might want to look at this one. Its argument did not figure directly in the conclusion of the court, but the did mention it twice in the opinion:
Steven Rosenthal, “Taxing Private Equity Funds as Corporate ‘Developers'”
You are living in interesting times.