Posts Tagged ‘fractions rule’

Disclosure:  Intel is currently the largest single individual equity holding in both my personal and most of my clients’ portfolios.   No shares will be recommended for sale based upon this original research.


Intel CEO Brian Krzanich

The purpose of this post, which will be accompanied with an email directly to top management, is to effect positive change and help Intel avoid an inevitable class action lawsuit by employees over mismanagement of its retirement plan.   Already Fidelity Investments itself and Massachusetts Mutual are subject to such lawsuits in which employees are claiming excessive fees and poor choices.  In both cases, employees are absolutely correct.


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Michael Dell Hopes SEC and IRS Are Sleeping


What continually makes the United States the place to be with respect to investment is the expectation that, when all is said and done, the rule of law generally prevails.   One need only visit  China, Japan and Russia to see that markets are generally manipulated by insiders.

The big story regarding Michael Dell’s proposed private equity led buyout has yet to be told and it is all about gaming SEC rules designed to promote fairness toward all equity investors, not just a few insiders, and more importantly also gaming key IRS rules.  A few key points:

1)  Tech firms like Dell aggressively compete regarding strategic acquisitions and nothing speaks louder than “cash” or shares assumed to have the potential to appreciate.  For most tech firms the largest source of cash is remarkably non-payment of taxes.  This is due to the large stock option generated tax deductions with no corresponding outlay of cash, deductions associated with restricted stock, etc.  These firms do not generally purchase shares on the open market to fulfill such commitments but rather simply print up new stock.

Put another way, if you can generate a billion dollars of tax deductions, you can effectively reduce your tax bill by 350 million, which is nothing short of cold hard cash in the bank, if you are profitable.  The biggest such deductions come from the issuance of stock or large write-downs of assets, for which there is no cash cost to the company.

If one compares Dell to Apple and Google it doesn’t take long to see that Apple and Google have been veritable tax deduction making machines via the issuance of non-qualified stock options.  Consider the following analysis based upon each companies most recently released 10K reports.  Also consider that large exercises in options at Apple and Google in the last 5 years have generated staggering tax deductions while Dell has generated little.

One could even argue that the whole anti-trust action against Google was misdirected in that the focus should instead be on tax rules that have created a situation in which they are relatively immune to competition.  What tax paying publishing company could possible compete with a firm like Google that “coins” cash, to quote Henry Blodget,  in the form of non-payment of taxes.

Although Apple did not issue any options in 2012, it like Google and Dell, is aggressively issuing Restricted Stock to employees.  Again, there is no “cash” cost to this since it is simply new stock being printed up.  In the old days such stock would be purchased on the open market, resulting in a cash outlay,  yet now it is just printed up.  Consider the following:

Dell Apple Google
Stock Price 2/5/2013        13.5       457.8        765.7
Average Option Exercise Price 25.4 127.5 405.9
Potential Tax Deduction per Share -11.9 330.3 359.7
Options Outstanding 143M 6.5M 8.5M

The key point is that Dell is so underwater with its options that it can’t play the game any longer.  What they need to do is go private, take a massive write-down and revalue the shares lower to create lower strike prices.

Management can then issue two classes of options, not unlike what Bain Capital has done with respect to its own employees participation in deals.  One class will have a greatly reduced exercise price that will accordingly result in massive tax deductions when exercised in a subsequent IPO, when Dell is taken public again.

The beauty of this well worn scheme is that the amount expensed for the options is declared when granted, not when exercised.  This often results in a tax deduction upon exercise years later that are ten times as great as the expense recognized.

If Dell is taken private such deductions can then be allocated among Dell and other taxable private equity partners and result in effective tax rates of close to zero.  This is because many private equity firms have tax exempt limited partners who have no use for tax deductions, examples being public pensions and foundations.   Tax deductions are unusable for tax exempts.

Those private equity firms like Silver Lake, whose largest limited partners are tax exempt investors, including Calpers that owns 10 percent of Silver Lake outright, use well worn schemes to allocate these deductions away from tax exempts, contrary to IRS rules, in particular the “fractions rule.”  Remarkably, there is not only no discussion of this important rule but also no enforcement.

Other major tax exempt investors in Silver Lake include the New Jersey Public Pension System.   Is it not ironic that New Jersey Governor Chris Christie excoriated the Republican party leadership for its slow response in providing Hurricane Sandy relief while the State and other public pensions seek to profit at every turn from “buyout” funds?  Especially when these buyouts decimate the very tax base relied upon to support the public pension system.

In a perfect world Dell would  also take a massive writedown now, prior to the buyout, so that this important value could be captured and quantified, that is the future tax deduction resulting from the write down.  What Michael Dell wants to do is wait until after the buyout and pocket a larger share of any such deduction for himself.

Clear disclosure of all existing unused net operating losses able to be used in future years should also be prominently disclosed.

Overall, this is a brilliant plan and would be just another day at the office if this were Bejing, Moscow or Tokyo.   Let’s hope for the sake of long term shareholders that both the SEC and IRS give Mike a call and say,  “nice try.”

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Note:  Analysis of Bain Capital Profit Sharing Plan in Separate Post

A leading reporter recently asked me to take a look at Mitt Romney’s 502 page tax return.  What resulted was a fascinating journey that will hopefully initiate a common sense dialogue on needed tax reforms.   Newt Gingrich’s return was also analyzed, yet revealed no substantive tax policy issues.

To be clear, I am a strong critic of large private equity and hedge fund “buyout” firms.  To me they are clearly no more than sophisticated tax deduction pyramid schemes.   Others might argue they are the very definition of crony capitalism and via “club deals” are creating abusive monopolies that are destroying open markets.

That said, it is also true that these large private equity firms pay very close attention to my work and jokingly refer to me as Sherlock’s Sherlock when it comes to financial analysis.  So here we go.

Photo of Mitt Romney and former Sprint CEO Bill Esrey

My first advice to Romney, after reviewing his return, would be to read about Bill Esrey, pictured above, the former CEO of Sprint, and his current battles with the IRS over tax fraud.  Esrey paid his trusted advisor, Ernst and Young, millions of dollars to set up tax shelters that were later ruled to be illegal and abusive, leaving Esrey with a $100 million bill to the IRS.   Since Esrey’s primary asset, Sprint stock, has lost most its value, he may have little chance of repaying the debt.  He later resigned as CEO of Sprint.

The real tale of Romney’s tax return is not about his income, but rather his tax deductions taken and whether a significant accounting and tax fraud is being manipulated by his “trusted advisor,”  Pricewaterhouse Coopers (PWC).  This firm is also the auditor of record for both Bain Capital and Goldman Sachs in addition to preparing the tax returns for key partners such as Romney.  Pricewaterhouse Coopers also audits many key Bain portfolio companies including  Domino’s Pizza.


SEC & Hoover filings show PWC is the auditor of record for Goldman Sachs and Bain Capital, and also prepares Romney’s Tax Returns

Role of Accounting Firms In Financial Crisis Not Addressed

Before we examine the specifics of this situation, consider that four major accounting firms now have a virtual monopoly on providing audit and tax services to America’s largest corporations.  There once were eight, yet due to the failure of Arthur Andersen and mergers, it is now the final four.  They are Deloitte, PriceWaterhouse Coopers, KPMG and Ernst & Young.

There has been far too little discussion of these firms’ role in the recent financial crisis and if there were ever a case for anti-trust enforcement they could indeed be “exhibit 1.”  Afterall, we the public provide these firms with the capacity to render audit opinions that are vital to ensuring the healthy functioning of capital markets.  My personal opinion is that no one firm should be allowed to render audit opinions on more than 10 percent of the firms listed in the Standard and Poor’s 500 Index.

Pricewaterhouse Coopers Involvement

When it comes to tax work, in particular calculating and allocating tax deductions among partners in private equity funds, Pricewaterhouse Coopers dominates the market.  They prepare the key summary doument, what is called a K-1.  In addition to Bain Capital and Goldman Sachs, their clients include Blackstone, KKR, Fortress and Oaktree,  all now registered with the SEC.

Pricewaterhouse Coopers, the audit firm, boasts that its Asset Computation Subsystem (ACS) “simplifies the management and calculation of tax deduction allocations.”   This system works in tandem with its Nominee Bridge data repository system that “collects, analyzes and cleanses partner data in real-time via a secure internet portal.”   The third key system, its Investor Tax Reporting Subsystem (ITRS) then “pulls together the partner data from the Nominee Bridge system and tax allocations from the ACS system to create the investor package and related K-1.”

That may be far more information than you need to understand Mr Romney’s return yet for those wanting to understand the specific mechanics, that is the basic informational plumbing used by Pricewaterhouse Coopers.

K-1’s are to Partners what a W-2 Is to An Employee

Now back to the K-1. Think of the K-1 as equivalent to a W-2 for an employee.  If you are in a partnership you are required to receive a K-1.  This document summarizes key data including your ownership share of the partnership as a percent, total distributions made to you and total expenses/tax deductions allocated to you, etc.  One might ask, why are Romney’s K-1’s blank except for a box that indicates federal tax paid, the amounts of which are nonsensically trivial?

For comparison purposes, let’s take a look at a normal K-1, that received by Oregon PERS for a partnership investment it has with a leading private equity firm, the Texas Pacific Group (TPG).  Yes, there are a lot of confusing boxes but let’s just focus in on three basic things that collectively will tell us most of the story.

Normal K-1 Disclosure: Oregon PERS annual K-1 received for investment in TPG Private Equity Fund

Explaining Key Sections of Normal K-1 Using Oregon PERS Investment in TPG as an Example

1)  Part II Section J on the K-1 shows the partner’s share of profits, losses and capital.   What this means is that Oregon PERS is entitled to 14.07 percent of the profits and loss allocations/tax deductions generated by the partnership.  This is critical information that has been removed from Romney’s K-1’s.   We don’t know whether he has a 2 percent interest or a 20 percent interest in each of the various partnerships.  Why is no one asking this question, especially given Bain Capital’s significant media holdings?  Especially for those partnerships that are shell Cayman Island based entities.

Romney also notes that he is invested in mostly mutual funds, just like regular Americans, yet that is false.  His primary investment is in partnerships, each of which provides him a K-1.   His various returns reveal that he is invested in more than 20 Bain Capital funds, along with numerous Goldman Sachs funds.  Note that all funds that begin with the letter B in the following listing, including Brookside, are Bain funds.  The notion that these are all held in blind trusts is ridiculous.  He should have instructed the trustee to not invest in Bain or Goldman funds given their close ties to him.

Some years ago I was surprised when Bill Gates Sr. told me that the Gates foundation had sold every single share of Microsoft stock, more than $20 billion. At the time I thought that was a bad decision, thinking that retaining 10 percent of the assets in Microsoft would be a good sign to employees at the firm.  Gates Sr.’s perspective is a good lesson for Romney in that Gates clearly wanted to avoid potential conflicts of interest.

Romney owned private equity funds in just one trust.  Each provides him a K-1.

2)  Going back to a normal K-1, Part II Section L on the K-1 shows the capital account with respect to the partnership, including the net increase and related distributions.  Note that Oregon PERS shows an overall increase in its capital value of $5.8 million yet took distributions of $10.7 million.

In contrast, Romney’s return has removed this part of the K-1.  This is critical information because what Romney shows as his net gain or loss on the tax return can be vastly different from what he took in total distributions.  Put another way, he might show $1 million of long term income on a fund in which he took distributions of $5 million.  And if he is being allocated significant tax deductions he is not really entitled to, those undisclosed deductions could bring his overall tax rate closer to zero.  (See related blogpost on fractions rule.)

Financial Engineering with Tax Deductions

The reason such big differences can occur between gains recognized and cash distributions from a partnership is due to the allocation of tax deductions.  These private equity firms have made a science out of such allocations in order to eliminate all taxes.

Most of his fellow partners in these funds are tax exempt investors.  These include foundations, endowments and public pensions.  These investors can’t use tax deductions since they are tax exempt and similarly their unusable deductions can not be allocated to taxable investors like Romney.  The big question becomes, are Romney and other private equity partners dipping into this pool of unusable deductions belonging to tax exempt investors via creative accounting and transfer pricing, or in a technical sense, are they claiming what I call “illegitimate carried interest deductions”  designed to reduce their carried interest income.

Back in the 80’s investors were investing $1 to receive $7 of tax deductions yet the loophole was closed via an arcane new rule called the fractions rule.  This rule has given the lawyers and accountants fits ever sense because it was so well written.  Some now call it the Mariana Trench of the IRS code given all the subsequent special rules and accomodations that have been enacted yet also failed to dent its basic purpose, that being preventing taxable partners from using unusable deductions belonging to tax exempt partners.

3)  Part III Section 9a of the K-1 shows the net long term capital gain (loss).  Put another way, these are basically the gains or losses allocated to the partner.  In the Oregon PERS case, these losses shown are unusable since OR PERS is a tax exempt organization.

Now that we have seen what typical K-1’s looks like, that resulting from Oregon PERS investment in a TPG fund, let’s now zero in on what Romney disclosed.  Here is a picture of one in which the only box disclosed is federal tax paid, in this case $52. Other K-1’s are identical with $23 and $7 taxes paid respectively.

Romney Goldman Sachs Hedge Fund Parters K-1’s, Only Box 15 was Disclosed

This K-1 disclosure is preposterous and dramatically illustrates how doctored Romney’s returns may indeed be.   Total taxes paid for three separate Goldman Sachs hedge funds are as follows:

Goldman Sachs Hedge Fund Parters, LLC,    Taxes Paid $52

Goldman Sachs Hedge Fund Partners II, LLC,    Taxes Paid $23

Goldman Sachs Hedge Fund Partners III, LLC,    Taxes Paid $7

It is surprising that Newt Gingrich has not highlighted investment in these funds given Romney’s criticism of his consulting to Fannie Mae.  It was indeed such funds that created the demand for toxic mortgage paper and derivatives, not Fannie Mae and Freddie Mac.

Is Romney Feeding at the Public Trough in Spectacular Fashion?

If the debate is, who is deeper in the public trough,  Romney is clearly the winner since he and his fellow Bain partners have leveraged their wealth mostly off tax exempt investment partners putting up the funds to do “buyouts.”  Buyouts that don’t improve the purchased companies’ long term prospects, but rather may be nothing more than modern day carpet bagging being enabled by noncompliance with key tax code provisions.

Key Rules Must Be Followed For Tax Exempt Partners

Partnerships are very flexible, thus explaining their popularity.  For example, if you are one of 10 investors in a private equity fund, you and your other partners can decide how to divide the benefits of ownership.  If I have significant income from other sources, I might be interested in receiving more than my share of tax deductions simply because they are more valuable to me than to another partner.  Similarly, one partner might be asset rich but cash poor and therefore receiving a cash distribution might be much more attractive to them.  This is all perfectly legitimate and legal, provided none of the partners are tax-exempt entities.

Put another way, the actual income from a partnership is of secondary importance to private equity partners.  What is really important are distributions, whether in cash, the allocation of tax deductions, etc.  You might think, yes, but how can you benefit if a company is not profitable?    The answer again is all about managing cash flow, not profits.

What buyout firms like Bain usually do is take out significant loans in the name of the companies they acquire, rather than in their own name, and then distribute that cash to partners in the form of a distribution rather than reinvest it in the business.   This is but one of many tricks designed to extract cash distributions to partners from the companies they purchase.  Of course a related goal is to make these distributions tax free.

Trafficking in Net Operating Losses

A second significant trick is that these private equity firms traffic in net operating losses that effectively allow them to convert many of the companies they acquire into tax exempt equivalent organizations.

Ask yourself, how can a local day care center compete with a national chain, such as Bain Capital’s Bright Horizons,  if the national chain is paying no federal or state income taxes?  And what is happening to these local communities all around the country is that they are seeing their tax bases decimated by Bain related takeovers of small and mid sized companies who were paying at least some level of taxes.

Of course one of the big tax deductions Bain Capital and other private equity firms take on the road to converting companies purchased to tax exempts is interest on debt involving leveraged buyouts.   This has become a veritable money tree.

Here is how it works.  You issue massive stock options and or partnership like ownership units to portfolio company executives at very low prices and then periodically revalue these companies to show significant gains so that when they are exercised you can capture significant tax deductions on the difference between the original exercise value and the market value at time of exercise.  You are essentially paying the option gains to yourself, the partners, on the backs of other investors and employees.

The beauty of this scheme is that these buyout firms determine the value of the companies themselves and the cost of these deductions is nothing but the ink and paper on which the stock certificates are printed.  They then pool these compensation deductions into massive pools of tax deductions, what are also called net operating losses in tax parlance.

Consistency, an Integral Accounting Concept, Appears Absent with Respect to Fee Recognition. Is Bain Capital Working From Enron’s Playbook?

In a testament to the self destructive nature of greed many private equity firms and their auditors may have gotten sloppy and violated key accounting “consistency” standards.  What they appear to be doing is removing key costs from the valuation of their portfolio companies, thereby inflating values and the resulting tax deductions when options or partnership units are exercised.  Here is a brief video explaining this scheme involving what they call “deal specific” carry fees.

While Enron made an art out of removing expenses and shifting debt to offshore entities in order to bolster its financial statements, thereby inflating income and its stock price, private equity firms appear to be shifting key expenses, including compensation and deal fees, down to portfolio companies they purchase and not reflecting them in valuations of those same companies that ultimately help determine the income they report to the SEC.   This may be an absolute violation of the “consistency” requirement.  Put another way, this is financial engineering gone astray.

This situation reminds me of the time 10 years ago when AOL’s then Chief Operating Officer, Bob Pittman, was noting that if advertising revenues were down, they could simply dedicate more space to affiliated companies.  Bob didn’t seem to realize that intercompany transactions must be dealt with differently and are not sales.  I often wondered where Bob landed after the Time Warner/AOL debacle and it turns out he is now Chief Operating Officer of Clear Channel, one of Bain Capital’s largest portfolio companies.  Could you possibly make this “stuff up?”  One need only google Pittman AOL Clear Channel to confirm this.

Convincing CEOs of Selling Companies to Sell Out Fellow Shareholders and Employees

The next step in this tax scheme is for Bain and other private equity firms to go out and purchase more companies and tell the CEO’s that if they sell to them, they can convert them to tax exempt status, which will allow them to lower prices and dominate the market.   Remember, next to wages, taxes are often the most significant use of cash.  While at Bain and Company, Romney was known, as the firm is still today, for optimizing cash flow planning models.  In layman terms, this means eliminating all taxes through financial engineering.

Often the executives selling their firms to private equity companies stay on after the takeover at the private equity firm.  The problem is that they often do not publicly disclose the accumulated operating losses or tax deductions the firm owns, a valuable bargaining chip, prior to the sale  They also often simply exchange their unvested options for new options/partnership units in the private equity firm.  Meanwhile, the remaining public shareholders lose the capacity to maintain a long term oriented investment.

Clearly, a key dynamic of this whole private equity/Bain Capital buyout phenomenon, which could be nothing more than a tax deduction pyramid scheme, is the involvement of tax exempt investors.  This includes endowments, foundations and public pensions.  Bain is typical in its reliance on these, ranging from State pensions in Massachusetts, Ohio, California and Pennsyvania to prominent foundations and endowments.

Put another way, no one has been more at the public trough than Mr. Romney and his private equity peers.  The reason is that these tax exempt entities pay no federal or state income tax on the gains from such leveraged speculative investments.  Congress tried to prevent this by requiring that tax exempts pay income on such gains to ensure a level playing field for domestic companies.

Romney’s Foundation Appears to be Violating A Key IRS Requirement Regarding Tax Exempt Status. Is It Time For a Flat Tax on All Tax Exempt Investment Income from Sources Other than Treasury Notes?

Perhaps now is a good time to advocate a flat tax of 10 percent on all tax exempt income coming from investments other than US Treasuries.  A related reform should be requiring that all tax exempts, including religious organizations, file an annual 990 disclosure form.  This is required of foundations, endowments and most other tax exempt organizations.  These filings are available at foundationsource.com and interestingly it appears that Romney’s foundation is violating key reporting requirements in that, rather than reveal the investments, it instead simply disclosed the accounts are at Goldman Sachs along with the total account balance.

In contrast, the Gates foundation and others meet the requirement by showing a detailed list of investments.

Blocker Corporations Used to Allow Tax Exempt to Skirt Rules

In order to escape this requirement that prohibits tax exempts from investing in leveraged buyouts, private equity firms set up corporations in foreign tax havens, blocker corporations, in which tax exempts such as Pennsylvania PERS invest.   If they did not do this, these tax exempts would have to pay tax on their gains, as they should for such leveraged transactions.  Without that, the market does not work because all tax paying companies would be at a severe competitive disadvantage and be driven from the market.

Being tax exempt is a great advantage in that one does not have to pay tax on investment gains, yet it also means that tax deductions are useless and unable to be bartered for other partnership benefits.  For exampe, CALPERS can not say to Bain, look, you take all our unusable tax deductions because as a tax exempt we can’t use them.  In return, you pay us an extra 10 percent return.  IRS rules strictly forbid this.

Nevertheless, my research indicates that many private equity firms appear to be using transfer pricing and allocation systems to allocate carried interest expenses paid by these tax exempts down to the private equity portfolio companies, often laundered through off shore taxable subsidiaries, in order to capture what should be unusable tax deductions.  Much of this is compensation and deal fee related.

Recap: The Story of Romney’s Return is more about the Deductions Taken, not the Tax Rate on Income

Only by seeing the complete K-1’s can this be revealed.  And if his accounting firm,  which could be at the center of this scheme via its ACS allocation system, is not allocating such deductions to Romney given his political status but rather to other taxable partners, that would be an equally large scandal.

My advice to Mr. Romney would be to fork onto the high road ASAP and openly support more fairness in the tax code by starting with making income by private equity managers taxed at ordinary rates and then talk about lowering rates.  Put another way, fairness before rates.

I would also recommend that he initiate an investigation into his accounting firm’s treatment of carried interest related expense allocations to determine if he indeed was being allocated such deductions. That could be resolved in a 5 minute phone call.

What Romney and the other candidates also need to realize is that there are two sides to a job.  The first is income and benefits to the employee and the second side is tax revenues to support the local communities in which they operate.  Would it not be interesting if Bain disclosed its total federal and state income taxes paid by Bright Horizons day care across all 50 states, and this were compared to local day care centers?   My guess is that it is close to zero.

If the Bain capitalism model is to use these and other creative maneuvers to drive competitors from the market and then raise prices resulting in an abusive monopoly, that is the very definition of crony capitalism.  Later in a separate blog post we’ll look at Bain Capital’s involvement with Clear Channel and Ticketmaster as a thought provoking example.

Bain and its partners were so anxious to complete the takeover of Clear Channel that they sued Citigroup and other leading banks at the height of the financial crisis in mid 2008 to force them to make good on commitments to finance the $22 billion takeover.

This is indeed a big untold story of the finanical crisis that led to mass layoffs as smaller and mid sized firms got locked out of the credit markets.  Rather than consumers not repaying their mortgages, the much bigger issue was firms like Bain sucking up all the banks’ available liquidity in order to do leveraged buyouts.

What resulted was an environment in which firms like Bain could prey on liquidity starved smaller and mid-sized firms.  The notion that Romney is a jobs creator or Bain’s form of creative destruction is healthy is laughable to any competent investment professional.

As Romney’s opponent Gingrich notes, private equity is an important component for job creation, yet clearly these firms must be distinguished from the “buyout crowd” led by Bain.   The buyout crowd is nothing but a self-destructive greed mill.  Those are strong words, yet Romney’s Bain is known within the industry for charging 50 percent higher fees than most, that is 30 percent carry rather than 20.

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The following letter was sent to SEC Chair Mary Schapiro and IRS Commissioner Doug Shulman on “tax day” with the hope they will jointly work at restoring the integrity of cash flow statements, without question the most important analytical tool for investment advisors like myself.  It is simply astonishing, given their material nature, that listed companies are not fully disclosing purchased and accumulated net operating losses nor the impact of complying with the “fractions rule” in the case of private equity partnerships.


Parish & Company
10260 S.W. Greenburg Rd., Suite 400
Portland, OR 97223
Tel:(503)643-6999 Fax:(503)293-3507
Email: bill@billparish.com

April 15, 2011

Mary Schapiro
Office of the Chairman
Securities and Exchange Commission
Mail Stop 1070
100 F Street NE
Washington, D.C. 20549

cc: Elise B. Walter – SEC Commissioner
Troy A. Parades – SEC Commissioner
Robert Khuzami – SEC Director
Doug Shulman – IRS Commissioner
Heather Maloy – IRS Commissioner Large Business Division
Walter Harris – IRS Director Financial Services
Elise Bean – Congressional Oversight Committee

Dear Chair Schapiro,

In 15 years as an investment advisor I have always done my best to support the SEC’s work, having led many key corporate governance related initiatives. Past Chairs Levitt, Pitt and Donaldson are all familiar with my work, which has also been reported in front page stories in leading publications including Bloomberg, the New York Times, Barrons and USA Today.


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Prior to the fractions rule, investors were investing $1 in order to get $5 to $7 in tax deductions.

President Reagan was so incensed that he signed into law new legislation, the “fractions rule,” specifically designed to end this scheme.  During this period no firm was more abusive with respect to tax avoidance than General Electric. Today Reagan’s reform is being challenged in an assault on taxpayer fairness led by the private equity firm Blackstone and its CEO Steve Schwarzman (pictured below left), in conjunction with the American Bar Association (ABA).  See my August 2010 blogpost “Blackstone: Private Equity or Public Theft,” for expanded background.

Before you consider the proposition of gaining $5 of deductions with a $1 investment preposterous, listen to the brief clip below of Sanford Presant of Greenberg Traurig, one of the nation’s leading real estate attorneys.  It is actually two short clips, the first is his introduction at a major tax conference and the second an explanation of what led to the fractions rule in his own words.

Presant is a national authority in this area and has had major roles with the ABA, in addition to heading up Ernst and Young’s real estate practice. The complete audio recordings for Presant’s remarks, in addition to those of Internal Revenue Service Associate Chief Counsel Curt Wilson, can be purchased at http://www.dcprovidersonline.com.

Also featured in the recording is Wayne Pressgrove of King & Spaulding, who makes a case to IRS Counsel Wilson for a revenue ruling to disable the fractions rule.   It is ironic that Reagan relied on the same law firm, King & Spaulding, to craft the fractions rule in the 1980’s, and these lawyers did brilliant work.

Audio Clip 1 (0:25)
Hear Sanford Presant Introduction and Background

mp3 file (for iPad users)

Audio Clip 2 (1:26)
Hear Presant Enthusiastically Explain How Investors Received $5 of Tax Deductions for Each Dollar Invested

mp3 file (for iPad users)

At a 2010 ABA conference, Internal Revenue Service Associate Chief Counsel Curt Wilson volunteered to sit on a panel and explained where the IRS stands on fractions rule enforcement. Wilson is introduced by Wayne Pressgrove of King & Spaulding.

Audio Clip 3 (3:32)
Hear IRS Associate Chief Counsel Curt Wilson Discuss the Fractions Rule

mp3 file (for iPad users)

Wilson notes there always seems to be “considerable angst” in the audience regarding compliance with this rule.  He added that one of the American Bar Association’s key initiatives was to amend the fractions rule. Remarkably, Wilson adds that he has seen almost no activity in this area at the IRS for years, either centrally or in the branches.  One might ask if this is just but another GE-like inspired scheme.

Earlier this year Wilson responded directly to me via email that the IRS was not planning to repeal the fractions rule.  However, the Treasury department’s February 2011 General Explanations of the Administration’s Fiscal Year 2012 Revenue Proposals were released and they include a repeal of the fractions rule (see page 90). Wilson now notes that someone else in his office is responsible for the fractions rule, yet he will not disclose who this is.

Why is this important for all investors?

This month NY Times reporter David Kocieniewski wrote a remarkable piece on General Electric, noting the company earned significant profits, yet paid no federal income tax in 2010.  The article also noted that GE maintains a “970” employee tax department headed by John Samuels, a former United States Treasury department official.

Such situations are important for all investors to consider because long-term cash flow is a primary determinant of  investor success.  Next to labor costs, taxes are often the most significant cash outflow for most businesses.  Clearly, tax avoidance alone is not sustainable long term and such a risk should be considered.   Other firms with significant such risk include Google and Cisco Systems.  The overall point again is simply, cash flow matters.

Given the opaque nature of these tax schemes at firms such as GE and Blackstone, it is often helpful to analyze them from the bottom up.   For example, Catalent Pharma Solutions is a Blackstone-owned company that files its own 10K with the SEC.   This provides valuable information including executive non-qualified (NQ) option agreements at Catalent and footnotes explaining how entities roll up to the Blackstone parent.   Much of this information is simply not available in Blackstone’s own 10K filing with the SEC.

The following list of entities shows exactly how Catalent eventually connects to Blackstone, its parent.  The Top Level partnership, Blackstone Holdings III L.P., appears in Blackstone’s SEC filings and org chart. It is mostly owned by tax-exempt public pensions. The carried interest fees these tax-exempt pensions pay is indeed Blackstone’s primary source of income, an expense to the tax-exempt pensions and revenue to Blackstone.

If Blackstone is manufacturing non-qualified (NQ) tax deductions at the Catalent wholly-owned subsidiary level, which are actually a pass-through of the carry fees (internal carry plan) paid from tax-exempt limited partners to company executives, then this could be a significant violation of the fractions rule.  Sound bizarre?   Perhaps that is the beauty of laundering activity through so many layers of entities, combined with transfer pricing algorithms managed by leading accounting firms. Keep in mind that Blackstone has hundreds of individual companies in its various partnerships.

Please note that given the opaque nature of these issues and related complexity, my hope is that a leading journalist will confirm the facts directly with Blackstone.  This material is not copyrighted and has been provided to both Gretchen Morgenson and Floyd Norris of the NY Times for review.  It was Morgenson who reported on my findings regarding the Microsoft Corporation in 2000, similarly noting a scheme which allowed them to pay zero federal income tax.  From an investment point, again, the key observation of this analysis is that “cash flow matters.”

One could argue that the only real company in this whole structure is Catalent.  Imagine how frustrated their competitors who pay significant taxes feel.  Perhaps this is the real nexus of the national debate over taxes.  Rates should be able to come down in all categories, yet this is simply not possible until the basic tax equity issues are addressed.   What we need is enforcement of the fractions rule, specifically with respect to compensation allocations, in my opinion.

Repealing the fractions rule is now the “Holy Grail” for many private equity firms, in particular with respect to the allocation of compensation deductions.  The 2012 Treasury Department revenue proposal refers to using a less restrictive rule that does not deal with the key issue involving tax exempt entities, perhaps returning us to the days when certain insiders can invest $1 and get $5 in tax deductions.

Despite all the controversy surrounding Reagan’s Presidency, one can be certain that he would have dealt with this nonsense swiftly.  We will soon see how the current Administration does.

These private equity firms failed to get the fractions rule repealed in Congress.  They then failed again in their request to obtain a revenue ruling, sponsored by the ABA, from IRS Commissioner Doug Shulman.  The ruling was designed to exempt compensation (carry fees) from fractions rule considerations. They now have remarkably gotten the United States Treasury Department itself advocating their cause per the 2012 Treasury Revenue Proposals which effectively repeal the fractions rule.

Somewhere out there is an underpaid lobbyist and about the only thing standing between their success in repealing the fractions rule is a good journalist.

The following letter was sent to Warren Buffett and his heir apparent, David Sokol, on March 24, 2011 because he like all investors will see diminished opportunities as companies are taken private by private equity firms such as Blackstone in order to implement what might be called a tax deduction pyramid scheme.

Interestingly,  Sokol resigned shortly thereafter on March 30, 2011.  By the way, does anyone really believe Warren Buffet would invest $9 billion in Lubrizol so Sokol could earn a profit of $3 million, perhaps the equivalent of a rounding error for his personal portfolio?  Similarly, does anyone really believe Sokol resigned solely based upon this investment?

In any event, here is the letter to Buffett, whom some argue is a leader in key corporate governance issues, including tax equity.

March 24, 2011

Warren Buffett

Berkshire Hathaway Inc.

3555 Farnam St.

Suite 1440

Omaha, NE 68131

cc: David Sokol

Dear Warren,

I hope you are well and enjoying things. The last correspondence we had resulted in that most memorable letter from David Sokol regarding the purchase of PacifiCcorp here in the Northwest.

The reason I am writing today is that I would like to reveal, similar to the work I did regarding Microsoft in 1999 that ultimately resulted in two reporters earning Pulitzer prizes and a veritable cottage industry of media tag alongs, a most astonishing taxation story. One that, if you do not address, will clearly hobble many of your portfolio companies.

On this issue, we should be on the same page. The challenge is that we will need to briefly visit what leading tax attorneys call the Mariana Trench of the Internal Revenue Code, that is the fractions rule, scheduled to be repealed per Obama’s 2012 revenue proposals. See link to blogpost titled “Blackstone, Private Equity or Public Theft,”at http://www.billparish.com

Recommendation: Have your top analyst take a look and confirm you will not only be priced out of many acquisitions but also see your portfolio companies hobbled if this is repealed. No matter how well run and efficient you are, and no matter how great the sloth at these PE firms, this will greatly impact you in my opinion.

There are many specific facets to this scheme yet they all revolve around ultimately allocating unusable tax deductions belonging to tax exempt partners to taxable partners. Most remarkable is that these are not real expenses such as depreciation but rather mostly compensation in the form of carried interest fees.

Substantive Facts:

1) Private equity funds now receive most of their funding from tax exempt sources, in particular public pensions. George Roberts and others now spend most of their time gathering such tax exempt investors.

2) The fractions rule was put in place to prevent GP’s like Blackstone and KKR from trading additional partnership benefits with tax exempts LP’s who had vast amounts of deductions that could not use, since they are tax exempt. As one leading attorney put it, investors were trading on tax benefits, at times getting 5-7 dollars of deductions for every dollar invested, and that is what brought us the fractions rule.”

3) Here is how the current scheme works and how it will cumulatively hobble you over time:

PE firms portfolio acquire companies and create vast stock option programs, what some call internal “carry plans,” and by doing so take NQ option deductions at the individual portfolio company level. In reality, this is nothing but a push down of the carry fees paid from mostly from tax exempts, which is non-deductible. These carry fees are an economic expense belonging to tax exempt, often booked as a balance sheet transfer, never hitting the P&L statement.

4) The reason this impacts Berkshire is that everything else equal, you cant compete on a long term cash flow basis with firms that pay no taxes at all In addition, as Roberts states, their strategy is to aggressively price competitors out of the various markets and then later raise prices.

While you may say, this won’t effect us Bill, do have one of your best analysts take a good took. Quite remarkable. I’ve also provided this information to the Internal Revenue Service yet they will not comment.

My basic point is that if the fractions rule is eliminated and compensation deductions, in particular carry fees, can be allocated without restriction by only needing to conform to more lenient rules, it will be one big mess. See http://www.billparish.com for link to blog post titled “Blackstone, Private Equity or Public Theft.”

5) IRS Perspective to Date: Curt Wilson in the office of passthroughs and special industries has noted in national ABA conferences that “although their is considerable angst regarding the fractions rule,”it has been off the IRS radar screen. He also responded to me via email earlier this year when I expressed concern over the ABA aggressively pushing for repeal, specifically lobbying him hard at national conferences, that the IRS did not support that. Remarkably, however, in February the Treasury issued guidelines for 2012 which include its repeal. When asked for additional information, Wilson replied that someone else is handling this in his office but I can’t get a response from him who this is, much less any specifics.

Please do take a look. and naturally I will make myself available if someone there would like to discuss in more detail. By the way, as you likely know, all four of the major CPA firms are making very significant revenues servicing private equity and hedge funds who aggressively use carry fees. I began my career at Arthur Anderson when it was a great firm in 1980’s. Perhaps helping prevent this repeal will also help prevent an Anderson like moment in the future for one of these firms. It is indeed possible that this is a bigger situation than LILO leasing.

Best regards.

Bill Parish

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Note (Not Copyrighted) : This basic post was updated December 10, 2010 given the current debate in Congress over extending the Bush tax cuts and numerous inquires regarding my position in this debate.  The purpose of this post is to highlight that although rates are important, perhaps more important are overall fairness issues associated with two situations in particular.  Put another way, why don’t we all forget about the rates and focus on basic fairness first.  Doing that should allow rates to come down in all brackets.

With the financial reform package now passed, all eyes are on the setting of specific rules regarding its implementation.  And while lobbyists attempt to direct the debate away from where it should be, let’s instead visit the core issue, tax rules.

This rollout of specific rules related to the Volcker Rule and related tax considerations will squarely position Paul Volcker, pictured on the lower left below and current IRS commissioner Doug Shulman, lower right, against Blackstone Group LP’s Steve Schwarzman and other leveraged buyout artists operating under the guise of “private equity.”  Why are tax rules key one might ask, especially if these rules have nothing to do with the debate over carried interest?

This is because two specific tax rules have profoundly shaped the current investment markets via a major impact on cash flow. They have also in a more basic fashion functioned as the seeds from which all the other market dysfunctions have originated. The purpose of this post is to briefly explain these two rules and then connect the dots.  Also see related March 31, 2011 post titled Blackstone Tax Engineers, Inspired by GE, attempt to repeal the fractions rule.  This post includes brief audio recordings from leading attorneys and an IRS official regarding the fractions rule.

1)  Net Operating Losses: This involves the practice of creating large pools of net operating loss tax deductions, mostly from unusable technology firms’ stock option deductions when these firms are bought by private equity funds.  These private equity firms then do leveraged buyouts of profitable companies and offset these profitable companies profits into the pool of losses to make the profitable companies tax exempt.

Back in the 1980’s this loophole was intended to be closed when Congress prohibited profitable companies from purchasing such losses and using them all immediately.  The new law required they be amortized over several years.   As former Senate Finance Chair Bob Packwood noted in an Oregonian article, the Treasury never foresaw firms escaping the loophole by using partnerships with large pools of losses to purchase profitable companies.   Essentially, the same transaction in reverse.

Who would think that a partnership whose primary asset were losses would be able to purchase profitable companies. All that was needed in the legislation to prevent this was the term “and vice versa.”  Remarkably, there has been no discussion of this amazing situation, perhaps the biggest tax story in 10 years.

2)  “The Fractions Rule” This rule was put in place at about the same time and designed to prevent tax exempt entities such as public pensions from trading tax deductions they were not entitled to use with taxable partners.  The fractions rule also was designed to discourage tax exempt entities from investing in leveraged buyouts (LBO’s) via partnerships with private equity firms and other taxable partners.   Clearly this would give such firms purchased an unfair marketplace advantage when competing with tax paying businesses.  Or put another way, who would be left to pay tax if all the tax paying firms got gobbled up by partnerships in leveraged buyouts fueled with tax exempt investor funds.

Perhaps one of the nations leading attorney regarding the Fractions Rule, Sanford Presant of GreenburgTaurig, put it best in a 2008 American Bar Association meeting when he said.  “Back then it was tough to get in to our Thursday night committee dinners, they were by invitation only.  Boy was it tough to get in to listen to some of these people and their intelligent pearls.  The real debates were… Can you get 5 to 1 write-offs.  5 to 1?  How do you get 7 to 1!  Everybody was trading on tax benefits and as part of all this backlash, we got the fractions rule.”

Presant is pictured below on the left with Wayne Pressgrove of King and Spaulding on the right.  These two brilliant lawyers represent the leading private equity and hedge funds.

In the ensuing years, once again the industry has attempted to sidestep the fractions rules intent, which applies only to “partnerships,” by using blocker “corporations” set up in the Cayman Islands and other tax havens.  As a trained CPA I find this most disappointing since the IRS rules should be based upon the “substance” of the economic activity rather than the form or structure.  In any event, there is a whole cottage industry of law firms selling advice based upon such  blocker corporation schemes.

A brilliant team of lawyers at King and Spaulding helped write the fractions rule and key to it is the expression “and vice versa.”  This is key because it would prevent the gamesmanship that has occurred with operating losses noted above. Put another way, it would limit allocating deductions from tax exempt to taxable partners in addition to allocating income from taxable partners to tax exempt partners.

What surprises many non tax experts is that these special allocation partnerships can have one set of allocation rules for taxable income and deductions, and a completely different set of rules for cash flow.  The second key aspect of this situation that is creating considerable uneasiness among taxable partners in these partnerships is the rule regarding substantial economic effect, that is, you can’t be simply moving deductions and income between taxable and tax exempt investors unless the transaction has “substantial economic effect.”

This is particularly important with compensation, the numbers of which can be particularly large with private equity and hedge funds.   Large CPA firms now have entire divisions focused upon transfer pricing and expense allocations yet again one has to ask the question, if these transfers do not have underlying economic effect other than moving deductions around, why is this allowed.

It is somewhat ironic that King and Spaulding, the same firm that helped draft the fractions rule, is now leading an effort via the American Bar Association to gut the fractions rule by exempting certain key expenses and transactions.  One recent King and Spaulding partner, Dan Coates, was just elected to the US Senate and expressed interest in being on the Finance Committee, which oversees these rules via the IRS.

We’ve given up on repealing it all together, the ABA notes, and so we are now trying to be more tactical.  This has resulted in the fractions rule becoming what one leading attorney calls the “Mariana Trench” of the Internal Revenue Code.  Perhaps it is also why there has been so little enforcement to date from the IRS,  as noted by Curt Wilson, Associate Chief Counsel in the the office of Passthroughts and Special Industries, at the 2010 ABA Mid Year Tax Section meeting. Wilson noted, I find this surprising especially given the level of angst in industry over compliance with these rules.  See my letter to Wilson opposing granting this revenue ruling.

As an investment advisor I find this remarkable given the current debate over extending the Bush tax cuts.  While smaller LLC based businesses pay federal, state, property and various other forms of taxes and fees, it appears that these private equity and hedge funds are skirting the rules and paying close to nothing.  This of course introduces a significant fairness issue.

Again, the fractions rule specifically limits the trading of tax benefits from tax exempt entities to taxable partners, or vice versa.  Put another way, imagine if you were a taxable partner in a partnership and 90 percent of the other investors were tax exempt entities?  Imagine how difficult it would be to leave 90 percent of valuable tax deductions on the table as unusable?

Perhaps this is why gutting the fractions rule is one of the American Bar Association’s top priorities. (See ABA letter to IRS Commissioner later in this post.)

It could be argued that some private equity firms have become but a sophisticated shell for tax avoidance based upon a maze of interconnected companies and effectively converted to tax exempt status through the aggressive use of net operating loss tax deductions involving executive compensation and transfer pricing.  This has resulted in an unfair competitive advantage against profitable companies that pay taxes.  This has also enraged ordinary small business owners who are not using such schemes.

Investors in profitable companies that actually pay taxes get lower returns than they otherwise would have, making competing with such a scheme on a long term basis difficult.  The situation is even worse for their productive employees who suffer job losses due to takeovers inspired by this scheme, and essential government services which rely on a broad tax base.  This could be the big untold story of the current economic decline, a decline inspired and manufactured by certain private equity firms.  It also explains in large part the constant drumbeat of job outsourcing in that the first thing these private equity firms do is outsource everything off shore possible, no matter the long term consequences.

Again, Congress supposedly foresaw this potential with passage of the “fractions rule”, Internal Revenue Code 514(c)(9)(e) in the late 80’s, to prevent tax exempt entities from trading deductions they cannot use with taxable entities.  One need only examine the growth in tandem of public pensions and private equity investment to see the dimension of this issue.

In the 1980’s the big issue was depreciation on real estate being given to taxable partners by tax exempt partners in exchange for other benefits.   If this were allowed to proliferate there would be no corporate income tax as private equity partnerships manage companies from a tax exempt status and drive tax paying competitors out of the market with lower prices.

One can forget that taxes are indeed one of the most significant business expenses and eliminating this expense would provide a significant competitive advantage for these private equity firms.

Private equity funds have grown dramatically since then, most notably Blackstone, KKR and TPG.  These firms now receive most of their funding from tax exempt public pensions, foundations and endowments, at times more than 80 percent for particular partnerships.  At the same time they are aggressively investing in businesses which derive most of their revenue from government programs.  A good example is Blackstone’s recent purchase of Oregon’s largest assisted living center, Sunwest, an entity whose primary source of sales are government medicare and medicaid payments.

Somehow the public has been fooled into thinking private equity is something other than a euphemism for leveraged buyout.  And while tax exempt investors, mostly public pensions, use sophisticated LBO strategies including  these Caymen Island based “blocker corporations” to avoid paying UBIT (unrelated business taxable income), they appear to have altogether neglected the significance of the “fractions rule” and basic economic substance requirements regarding allocations of financial results.

Congress set up the UBIT rules specifically to avoid a situation in which tax exempt entities are partners in private equity partnerships and investing in leveraged buyouts, to maintain a level playing field.  The idea was to tax these tax exempt entities on profits gained from such leveraged buyouts, that is UBIT tax.

As noted, the UBIT rules regarding leveraged buyouts have  however been circumvented through the use of off shore “blocker corporations” set up as an intermediary so that the tax exempt entities are seen as investing in a corporation rather than a partnership in which activity flows directly to them as a partner, for example profits and tax deductions.

Nevertheless, the fractions rule math is pretty simple as follows: if for example 70 percent of Blackstone’s investment partners are tax exempt, then 70 percent of certain tax deductions are unusable and can not be transfer priced or allocated into a situation, whether by using equity compensation, carry fees or other expenses in which they are transferred to and used by taxable partners.

While the nation debates whether to tax private equity and hedge fund partners at ordinary or capital gains rates, more interesting is whether or not these partners like Schwarzman are in clear violation of existing IRS tax rules due to an aggressive tax strategy using stock options and carry fees, and other deductions.  Once these machinations are fully understood, the tax benefits could be disallowed if the fractions rule has been violated.

As an example, let’s briefly examine the Blackstone Group more closely, whose President Tony James visited Portland, Oregon in July 2010.  Blackstone is arguably the global leader in private equity investment.  They are also a major risk for investment advisers like myself given their ability to takeover good companies and remove them from the marketplace.  This makes my job much more difficult, not only in selecting good investments, yet also in maintaining clients who suffer an unnecessary job loss due to one of these senseless takeovers that are now proliferating.

Blackstone and other private equity firms including KKR and TPG essentially set up partnerships with tax exempt entities like Oregon PERS, LLC’s,  and often have as little as 10 percent of their own equity in the deals.  “Tax efficiency reasons” are often cited for private equity funds’ low equity participation.  The partnerships then do buyouts of both public and private companies.  The above agenda summary is from a recent presentation by Blackstone in Oregon.

As Tony James noted in his presentation which led to a $200 million investment in a Blackstone partnership, they can now use Blackstone stock as currency to attract top executives by swapping out their unvested stock options for Blackstone options.

That may be convenient yet IRS rules are very clear in prohibiting the trading of valuable tax deductions between taxable entities and tax exempt entities such as public pensions due to abuses in the 1980’s.

Specifically, the “fractions rule”., IRC, 514(c)(9)(E)  was adopted and it only allows the taxable entities to take their share of economic interest in the partnerships.  For example, the taxable partners could only take 100 percent of the equity compensation tax deductions when there are no tax exempt partners.

What it also does not allow is an aggressive strategy using transfer pricing and allocations to circumvent the rule.  Such strategies may reduce tax exempt entities exposure to UBIT yet the fractions rule must still be met.

What the IRS clearly did not want was tax exempt entities like CalPERS and Oregon PERS taking a greater share in profits in lieu of trading unusable tax deductions, deductions they were not entitled to  as a tax exempt entity.  A related specific purpose of the rule was to provide a disincentive to do leveraged buyouts, thereby capturing large interest expense deductions and allowing taxable partners to avoid all tax on their profits.   And while Congress debates whether or not to levy ordinary income or capital gain tax rates on private equity managers, it is conceivable that a tax rate of 75 percent could still result in no tax being paid by general taxable partners such as Blackstone’s Schwarzman.

Many creative and aggressive tax strategies have been adopted by large law and accounting firms to try to get around this fractions rule.   These firms, once referred to as the Big 8, yet now the “Final 4,” all have large divisions focused on hedge funds, private equity and transfer pricing related strategies, to minimize taxation.  In addition to being Blackstone’s auditor, Deloitte is also the auditor of record for Oregon’s private equity portfolio.

The question becomes, are the taxable partners at Blackstone using capitalized carry fees and aggressive transfer pricing rules to avoid all taxation?  My practice includes roughly 20 PERS participants here in Oregon and I made a public records request for Blackstone, KKR and TPG’s K-1 partnership filings, yet was told that Oregon does not receive them for most partnerships and for those it does, maintains no file of them.

Remarkably, the Oregon Attorney General’s office adopted the philosphy that since Oregon PERS is tax exempt they need not ask for nor review this critical document reported to the IRS, but rather rely exclusively on documents prepared by Blackstone, KKR and TPG for information.  For this reason the OIC does not even maintain files for K-1’s in general.  This is somewhat ironic since the current Chair of the Council is Harry Demorest, former managing partner of Arthur Andersen’s Portland Office.  Demorest  managed the tax practice at Arthur Andersen before assuming control over the entire office and clearly if anyone should understand the importance of receiving a K-1, it is Demorest.  Another council member, Richard Solomon, is also a practicing CPA.

The following are samples of the few K-1’s they maintain at Oregon PERS.  They are for KKR and TPG  and were obtained via public information request.  When asked for a simple description regarding the accounting treatment for carry fees, which do not appear directly on these K-1’s as capital transfers,  the Treasurer’s office refused to provide this information.

One obvious question is why the K-1 capital accounts are so low in relation to the publicly available investment summary by partnership.  Many things could explain this yet where is the basic transparency.  And why won’t the Oregon Investment Council even disclose the accounting treatment they are using for the significant carry fees being paid to general partners?  Also of interest is perhaps that KKR’s K-1 is done on a “tax books” basis while TPG uses GAAP accounting.

One could argue that tax exempt investors have nothing to gain from receiving a K-1, yet that is simply ridiculous.  The K-1 is a key document that includes information regarding values, distributions, etc.  My guess is that this is prevalent among public pensions and would it not be interesting to compare the K-1’s provided to taxable partners to those provided to tax exempt partners?

These private equity firms are famous for providing a wide range of “figures” on key reports and related valuations.   The Financial Times, (see summary visual) has reported that Blackstone valued one  investment at 125 percent higher than TPG when even though this investment is in the latter company for an equal amount.   These valuations are critical because they drive transfer pricing, related deductions and allocations, etc.

Goldman Sachs even has its own internal specialized exchange which values private equity interests and is where many such private equity interests are bought and sold.  It is called the GSTrUE system and is only accessible on approved Bloomberg terminals.  Remarkably, not even the Institutional Trading areas at TD Ameritrade or Charles Schwab have access.  Perhaps this “dark exchange” needs a little daylight cast, especially since the biggest investors in such partnerships are taxpayers via the various public pension systems.

Let’s face it, taxes can be boring yet this discussion is important to all investors given that the current level of “buyouts” is removing many quality investments from the market that are later loaded up with debt so that the private equity firms can more quickly earn their “carry fees,” which are generally 20 percent of all profits after returning the original investment to partners.   What also results is a job destruction machine that undermines the economy and stability of the financial markets, not to mention the tax base.  Most importantly, this undermines investor confidence with the perception that investing has become an insiders’ game of manipulation.

Here is a summary of a few potential “discussion issues” to consider affecting just one private equity firm, Blackstone.

1)  The CEO of Blackstone Tony James noted in a public meeting in Oregon that Blackstone options are being used in exchange for unvested options for various purposes, including attracting key management talent.   He also noted that Blackstone uses numerous internal “non-profit” cost centers to serve its various portfolio companies in the subsidiary partnerships, many of which have tax exempt investors.   The question becomes how this impacts transfer pricing and the allocation of valuable tax deductions.

One related question is the following: by manipulating the cost of products and services provided to portfolio companies, are they essentially creating compensation related carry/stock option tax deductions at the Blackstone level to be allocated to taxable partners, when they belong to tax exempt investors and should be unusable?

2)  Blackstone’s 10K for the period ending 12/31/2009 does not disclose what would be material adjustments for disallowed equity compensation deductions belonging to tax exempt investors.  These pertain to equity compensation in which the executives provide services to portfolio companies.  At the July 2010 Oregon PERS  public meeting, James used the example of hiring Gerry Murphy of Kingfisher, one of the UK’s largest firms, by swapping his unvested options for Blackstone options.  James also highlighted the service Murphy provides to specific portfolio companies in the partnerships.

If Blackstone is creatively allocating expenses to its various partnerships, why hasn’t it disclosed the portion of this equity compensation and other related deductions which should be disallowed because they belong to tax exempt partners via an allocation of related expense.

Blocker corporations may solve their UBIT tax issues, yet the fractions rule must also be independently satisfied.

Many other related questions arise when exchanging options for firms acquired.  These deductions need to stay at the acquired firms, yet their value would have been created by the transfer of the Blackstone options, even if the Blackstone Group LP company is not taking a deduction.

Where is the disclosure in Blackstone’s 10K regarding the disallowed carry executive compensation expense?  The firm recognized almost $24 billion of such carry related compensation expense reducing its income by more than $3 billion in 2009.

3)  The Blackstone 12/31/2009 10K displays the line item stating “non-cash equity compensation” of $3 billion.  This resulted in a net loss as shown of approximately $2.4 billion in 2009.

If this entire amount of equity based compensation listed above pertains to a tax deduction, as it usually does with respect to such a line item on a “cash flow statement,” this would imply that Blackstone pays no federal income tax for activity in 2009.

Granted they may indeed pay tax related to other areas, for example, property tax, timing differences from prior year.  The key question becomes, how much of this equity compensation amount pertains to services provided to portfolio companies and what part should be disallowed given that the portfolio company is now partly owned by a tax exempt entity?   Also, is this a material omission by Blackstone’s auditor, Deloitte?

4)  The Chair of the Section on Taxation for the American Bar Association wrote the following letter directly to the IRS commissioner Doug Shulman on January 19, 2010 concerning partnership allocations permitted under section 514(c)(9)(E).    What he is specifically asking for is a revenue ruling to permit more aggressive strategies with respect to the allocation rules regarding partnerships with tax exempt entities, i.e, violating the spirit of the fractions rule.  The entire letter with extensive comments can be accessed on-line with a Google search.

Following the letter in this blog post is a list of clients for the lawyer whose firm King &  Spalding was a key contributor in authoring the letter.

The key attorneys noted as contacts involved with drafting this letter to IRS Commissioner Doug Shulman on behalf of the American Bar Association are the following.

In a testament to their legal prowess, the first attorney noted works for King & Spalding, a firm that lists three of the four largest CPA firms, Price Waterhouse Coopers, Ernst & Young and KPMG as  clients, along with Goldman Sachs, Citigroup, Bank of America and Wells Fargo.

At the same time the ABA is seeking a revenue ruling waiver from the IRS, the private equity and hedge fund industries are pursuing a simultaneous track in Congress.  This was introduced in the 110th Congress and reintroduced as H.R.3497 in the 111th Congress.  Both bills are sponsored by Sanford Levin of Michigan (not to be confused with younger brother Carl Levin in the U.S. Senate).   H.R. 3497 has only three co-sponsors and has been referred to the appropriations committee where Sanford Levin is chairman.

Perhaps most interesting is that at the same time U.S. Representative Sanford Levin is introducing a bill that could dilute the fractions rule, he is also introducing another bill, H.R. 1935, to tax private equity partners at ordinary income rates.  The irony is that his one bill, H.R. 3497, could indeed result in no tax, regardless of the rate.

Meanwhile his younger brother Carl Levin is co-sponsoring a bill with Jeff Merkley of Oregon designed to help states avoid teacher layoffs.  Carl Levin has also been a leader in the effort to reform stock option accounting.  It is unfortunate that a key driver in the funding gap in state governments is increased Public Employee Retirement System contributions due to significant investment losses and concern over the lack of liquidity with respect to their private equity portfolios.

I have some simple advice for the current administration.  Aggressively enforce the fractions rule and prohibit tax exempt organizations from using blocker corporations or any other vehicle that ultimately results in a leveraged buyout within three years of a firms’ acquisition by a partnership in which they participate.  If we simply eliminate the fuel for these senseless takeovers, that is tax exempt pension and endowment money, we’ll go a long way toward protecting good companies along with their employees and current investors.

For those of you wanting to enjoy a little Sunshine and rub shoulders with Wayne Pressgrove and other key voices from the American Bar Association in this debate, including leaders at the Internal Revenue Service, consider attending the upcoming conference in January at the Boca Raton resort.  Details are provided below.  Perhaps it is somewhat ironic that indeed the Blackstone Group now owns the Boca Raton resort via one of its real estate partnerships.

Perhaps also ironic is that Blackstone’s novel approach of issuing a publicly traded security on the New York Stock Exchange, one that is not a stock but rather a partnership allowing tax benefits to flow directly to general partners, may afterall allow many of those same benefits, if indeed such deductions lack economic substance, to flow right back to the Treasury.   For taxpayers, both individuals looking at higher rates and corporate alike, including the likes of Warren Buffett who has roundly criticizes this structure,  this could amount to “sweet justice.”

Perhaps my alma matter, the University of Oregon, may indeed set a good precedent by defeating the Auburn Tigers, Pressgrove’s alma matter, the week prior in the BCS championship series.  Spending several hours putting this post together should allow me at least a little comic relief 🙂

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