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Tax News
Carried Interest Loophole – Maybe not in Texas!
August 24, 2015
Cases
A few days ago the U.S. District Court for the Southern District of Texas issued an opinion that offers a glimpse into the 5th Circuit’s thinking on the carried interest issue. The decision is United States v. Stewart et al. and could be found here. In this case the U.S. sued two partners in an oil and gas partnership. The facts are as follows.  In year 2003, an investor named Hydrocarbon Capital, decided to acquire a portfolio of oil and gas properties from an unrelated corporation. However, the investor did not have the expertise to run and manage the properties. Therefore it arranged with 5 executives from the seller’s corporation to manage the properties. The executives formed a partnership, Odyssey Capital Energy which operated the wells and paid expenses. The parties agreed that if the oil and gas assets are sold, Odyssey Capital were to receive 20% of the revenue. Hydrocarbon on the other hand had a priority return of capital plus a 10% return on investment. To people familiar with private equity funds, the above would sound familiar. One of the differences here was that Odyssey and Hydrocarbon did not have a formal partnership agreement.

So what happened down the road? After couple of years the parties sold the asset at a significant profit. Odyssey picked up its 20% and reported it to its partners as ordinary income. Two years later, the partners apparently got smart on the issues and amended Odyssey’s return and their own returns to reflect capital gain. The IRS approved the amendments and issued refunds to the partners. Subsequently, it filed a District Court lawsuit to recoup the refunds. The Government’s argument was that the parties were not partners in a tax partnership and that Odyssey earned a commission instead of distributive share. In rejecting the Treasury’s claims the Court reasoned as follows. First, no formal partnership agreement is required to have a partnership for tax purposes. Second, and more importantly, the arrangement was no different than flipping a house. The Court put it as follows: the gain realized through sweat equity - the appreciation in the value of the house by fixing it up - is a capital gain. This is the very reason it is called sweat equity instead of sweat income. In the same way, Odyssey’s sweat, their management, increased the value of the capital, the portfolio of properties.  Thus, the Court ruled for the taxpayer.

Now, at 5 pages, this decision is by no means a paragon of technical tax analysis. Moreover, the decision would likely not be persuasive authority going forward, if and when, the carried interest bill is enacted. However, very succinctly and in layman terms, the decision nails the central issue surrounding carried interest. Sweat Equity.  Sweat equity is sweat equity and if it is going to be taxed as ordinary income it ought to be taxed as such to everyone, not only hedgies or PE GPs.  A host of private equity firms would say that Judge Hughes got it right. And who knows, Texas may get some of that Connecticut and NY business in the near future. 
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Tags: Carrid Interest, carry