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Volcker Board Proposes Changes in Taxation of Investment Funds as Part of Reforming Federal Tax Code

By Jim Hamilton

A report issued by the Volcker Tax Advisory Board proposes the reform of mutual fund and carried interest taxation within the scope of a broad simplification of how the Internal Revenue Code taxes capital gains. The report comes against the backdrop of pending but stalled legislation that would reform the carried interest taxation of hedge fund and other asset managers. The Board is chaired by former Fed Chair Paul Volcker and includes former SEC Chair William Donaldson. The Volcker Board, officially the President?s Economic Recovery Advisory Board, has a mandate to simplify and reform the federal tax code.

Capital gains are taxed at the individual level at special rates which depend on factors like the type of income or type of asset, the holding period of the asset, and other accounting rules. Long-term capital gains and qualified stock dividends are taxed separately from other income. A source of complexity arises when a capital gain has occurred and thus when taxes are due. An exchange of property, such as a sale, generally is a taxable transaction, for example, you pay the tax when you sell an asset. However, several provisions allow taxes on capital gains income to be deferred or for the gain to be calculated differently, said the Volcker Board, adding complexity and providing incentives for socially unproductive tax planning. For example, present law provides that *no gain or loss is recognized if property held for productive use in a trade or business or for investment purposes is exchanged for like-kind property (a Section 1031 exchange).

Another area of concern is the taxation of carried interest. The manager or general partner of a hedge fund or investment fund typically receives two types of compensation: a management fee and a percentage of profits generated by the investments called a carried interest. The management fee is taxed as ordinary income, but the carried interest is generally taxed at the lower capital gains tax rate to the extent that the underlying investment has generated long-term capital gains eligible for the lower rate. Many tax experts consider some or all of the carried interest as compensation for managers? services, and therefore argue that some or all of this compensation should be taxed as ordinary earned income, as is performance-based pay in other professions.

The Volcker Board proposes harmonizing the rules and tax rates for long-term capital gains. Preferential rates would be eliminated. Investors in mutual funds currently have the choice of using several different methods of computing their basis for purposes of computing capital gain. They can choose the average cost basis method, the first-in, first-out method or the specific identification of shares method. Specific identification
is the most taxpayer friendly as it allows selling those shares that have the highest cost and thus the lowest capital gain first. First-in, first-out is generally least taxpayer friendly as the oldest shares are more likely to have been purchased when stock prices were lower, resulting in a larger taxable gain. The average cost method would generally be in between these two methods. With new reporting of basis requirements in effect, however, this creates the potential for confusion and errors if taxpayers use a different method than used by the mutual fund.

The Volcker Board believes that requiring standardization using the average cost method for all shares in a particular mutual fund account would provide the greatest simplification and be a compromise among the methods available. Taxpayers would still have some flexibility as separate accounts would be treated separately. As a transition measure, this could be mandatory only for new shares purchased after date of enactment
(or alternatively starting at the beginning of that calendar year). This option would also
help improve compliance as over time all mutual-fund gain information would be computed and reported by mutual funds. The Board conceded that one disadvantages would be that some mutual fund investors would face higher effective tax rates on their mutual fund investments.

The small business stock exclusion in Section 1202 of the Code has a highly complex set of requirements that must be met throughout the holding period of a shareholder who hopes to benefit from the exclusion. The complex requirements are designed to prevent abuse of this generous provision. In addition, the Small Business Investment Act has been repealed, and there are now only a few small grandfathered Specialized Small Business Investment Companies (SSBICs). Because capital gains tax rates have declined substantially and the excluded gains are taxed as a preference under the AMT, reasoned the Board, there is almost no benefit from these exclusions.

Both the small business stock exclusion and the rollover of qualified small business stock gains have suffered from compliance issues because of limited reporting requirements and enforcement by the IRS. The IRS does not receive third-party information on eligibility of stock owners of potentially qualified small business stock, making the provision difficult to enforce. The rollover provision has also been criticized because of the short six-month holding period, which mainly benefits insiders and traders rather than long-term investors. This provision has been described as a tax benefit allowing a zero capital gains tax, but some small business investors do not re-invest their gains in replacement-qualified small business stock.

The President proposed a zero percent capital gains rate on equity investments in small businesses and a 75 percent exclusion was enacted for investments in 2009 and 2010 as part the American Recovery and Reinvestment Act. Some simplification could be achieved by allowing the 100 percent exclusion for stock purchases starting in 2009 and changing the prior 50 percent exclusion off ordinary income tax rates to a 25 percent exclusion off capital gains rates.

This simplification would retain the extra incentive for qualifying small business investments and result in similar effective tax rates while greatly simplifying the tax calculations. The alternative of repealing these special small business provisions for pre-2009 investments would still provide these investments with the benefits of the general preferential rate for long-term capital gains. Whatever option is chosen, improved reporting is required to help prevent abuse of this provision.

The Board also suggested that the rollover of gains from qualified small business stock (Section 1044) into an investment in another qualified small business stock could be repealed or reformed by lengthening the holding period from six months to at least one year. In the Board?s view, the short six-month holding period requirement is inconsistent with the patient capital rationale for special small business stock incentives.

Full post as published by Jim Hamilton's World of Securities Regulation on August 29, 2010 (boomark / email).