By Sean Vanatta
This year's Republican nomination battle has again highlighted the contentious nature of the U.S. tax code. And with regard to Mitt Romney, the founder of private-equity firm Bain Capital LLC, the argument has grown especially heated over the categorization of income and capital gains.
Many analysts have questioned the tax policies governing an important component of Romney's income, a form of compensation known as "carried interest." Portrayed in the press and academic writing as a modern product of hedge funds and private equity, carried-interest arrangements and the tax issues surrounding them actually have a long history, linked to oil speculation and wildcatting at the turn of the 20th century.
Carried-interest agreements are a type of delayed compensation used in investment partnerships, where one party (the "carrying" party) contributes the majority of the financial capital, and the other (the "carried" party) contributes assets that can only be made profitable with the infusion of the carrying party's money. If the development of the carried party's assets proves profitable, then the parties typically divide these profits at some pre-arranged percentage.
In the case of private-equity partnerships, this means that general partners, such as Romney, act as the carried party, primarily contributing entrepreneurial knowhow and the ability to turn around troubled companies, while the limited partners act as carrying parties, contributing capital to exploit these opportunities. If an investment in a company succeeds, then the profits are typically divided when the company is sold, with the general partner usually receiving 20 percent of the proceeds.
The process works similarly in oil-exploration partnerships, where carried-interest agreements have been used since at least 1906 and probably earlier. Here, the carried party, usually the owner of an oil lease, would contract with the carrying party, who would provide the capital necessary to drill a well and begin extracting any available oil. If the claim paid, then the two parties would usually split the profits once the carrying party was reimbursed for the initial exploration costs.
In these earlier cases, the carried-interest arrangement linked two distinct types of speculation: First, oil lessees who, in many cases, had purchased extensive unproven mineral rights in the hopes that these interests could later be exploited or sold; and second, wildcatters willing to risk capital to drill in unproven ground. Carried interest gave each party a stake in the total output of the well, a potent enough incentive to spur oil development.
Still, why these arrangements emerged at all is a question that requires some historical speculation.
After the Civil War, the U.S. experienced a mineral-exploration boom -- primarily linked to yellow instead of black gold -- which continued into the 20th century. Much of the speculation on this exploration was financed through stock sales on East Coast and European markets, and many of these ventures ultimately went bust, some spectacularly so. Capital continued to flow into such securities, however, because the real and imagined mineral wealth of the West fed the appetites of American and foreign investors looking for easy chances to strike pay dirt.
Yet the turbulence of the stock market also chastened some investors, who may have had a continued interest in mineral speculation, but wished to avoid the chicaneries of the unregulated securities markets. For these investors, a carried-interest arrangement would have offered a way to bypass risky stock schemes and exercise more careful oversight of their investments, especially as the turn-of-the-century oil boom opened new lands for speculation. These investments may not have been safer -- drilling dry holes was always a possibility -- but the carrying parties might have found more control.
Like their private-equity progeny, oil-exploration partnerships using the carried-interest model became publicly visible only when the federal government took an interest in taxing their profits as personal income. These tax cases began to enter federal courts in the 1920s as litigants challenged the government's categorization of their activities, with disputes ranging from the nature of resource-depletion deductions to whether carried interest could be categorized as compensation for personal services.
In the early 1950s, geologist William Frazell was a partner in a carried party involved in oil exploration in Texas. While his partners provided the capital in the venture, Frazell offered only his skills as a geologist, for which he was to receive a percentage of the oil discovered. Frazell, as it turned out, was a very talented geologist, and the partnership successfully developed a number of wells.
Instead of dividing the profits directly, however, Frazell and his partners created a corporation to manage the oil assets and Frazell received a 13 percent stake in this new company. Yet because he hadn't contributed any financial capital to the arrangement, a federal court decided that Frazell's share qualified as income in payment for his geological services, not a capital gain, and he was forced to pay taxes at the standard rate.
Although it isn't clear that Frazell’s case directly influenced how private-equity companies are structured today, the court’s ruling shines light onto the tax treatment of general partners’ carried interests. While general partners primarily contribute entrepreneurial energy to private equity, they must deliver some financial capital as well to avoid the kind of taxation Frazell experienced.
Whether this is a suitable reason to consider their carried interests as capital gains, instead of income, is the subject of much debate. If Congress takes up the issue again in the next few years, there may be a president in the Oval Office with a carried interest in the outcome.
(Sean Vanatta is a graduate student in history at Princeton University. The opinions expressed are his own.)
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-0- Feb/24/2012 15:28 GMT