Notice & Comment

The IRS’s Private Equity Regulations Might Backfire

In a post last week , my co-blogger Daniel Hemel explained how Section 707(a)(2)(A) may allow the IRS to deny the tax benefits associated with so-called carried interests, even in the absence of legislative action. That statute essentially grants the IRS the regulatory authority to alter the tax treatment of transactions between partners and partnerships, when those transactions are “properly characterized” as having occurred outside of the partner-partnership context. If the statute applies to a carried interest arrangement between a private equity firm (the partner) and a private equity fund (the partnership), then income allocated to the interest, which would usually enjoy capital gains treatment, will face the higher rates that apply to ordinary income.

Hemel notes that Section 707(a)(2)(A)’s legislative history describes several factors that the IRS should take into account in exercising its authority under the statute, and that those factors largely support the private equity industry’s claimed tax treatment. Consequently, to the extent that the legislative history materials control the IRS’s exercise of its regulatory authority, section 707(a)(2)(A) provides little help regarding the attack on carried interest arrangements. However, Hemel doubts whether “the legislative history matters much.”

I fully agree with Hemel that the legislative history should not matter. In fact, I would never treat legislative history as an authoritative expression of legislative intent. Because Section 707(a)(2)(A)’s plain text does not incorporate the factors described in the legislative history, the IRS should be able to adopt different factors, as long as its interpretations remain consistent with the actual statutory language.

However, the IRS may have shot itself in the foot here. Recently, the agency issued proposed regulations under Section 707(a)(2)(A), principally designed to address another private equity tax strategy (“management fee waivers”). The proposed regulations, the IRS notes, “generally track” the factors in the legislative history of the statute. Though the listed factors purport to be nonexclusive, the “most important” factor relates to the presence of entrepreneurial risk.

If the IRS follows through with these regulations (potentially doomed for different reasons), it will likely have to give up on addressing carried interests through Section 707(a)(2)(A). Though the proposed regulations are drafted with fee waivers in mind, they apply generally to determinations under Section 707(a)(2)(A). And given the regulations’ focus on entrepreneurial risk, they would not provide much help in combatting the tax benefits associated with carried interests — the risk factor generally favors private equity firms.

To keep its options open, the IRS might announce that its regulations do not apply to carried interests, and that it will announce different factors for determining whether a carried interest arrangement is “properly characterized” as occurring outside of the partnership context. However, this would likely violate the anti-chameleon principle of statutory interpretation — a statute’s words or phrases (e.g., “properly characterized”) cannot mean one thing in one context and a different thing in a different context. See, e.g., Clark v. Martinez, 125 S. Ct. 716 (2005). If the IRS applies factors to carried interests that vary widely from the factors that it applies to fee waivers, it would, in substance, be simultaneously (and improperly) promulgating two different interpretations of “properly characterized.”

To get around this issue, the IRS might reduce the regulations’ focus on entrepreneurial risk, but doing so would put it in a weaker position regarding its attack on fee waivers (in that context, the risk factor favors the IRS). Also, if the IRS treats the risk factor as just another nonexclusive factor, one must wonder what meaningful guidance the regulations would even provide. Recently, the 7th Circuit chided the IRS for its “goofy” approach of announcing factors in regulations while warning that they are nonexclusive, and the Section 707(a)(2)(A) regulations would continue that goofiness, but for their special emphasis on entrepreneurial risk.

As various commentators press the IRS to exercise authority under Section 707(a)(2)(A) to address carried interests, they should keep a close eye on what the IRS is doing on fee waivers. If the IRS finalizes the fee waiver regulations, it may have foreclosed its principal statutory argument on carried interests, and commentators will have to press for a different type of executive action. And those concerned with fee waivers might actually prefer a less potent set of regulations than those proposed, so as to leave some flexibility to address carried interests.

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