Bill Parish
10260 SW Greenburg Rd., Suite 400
Portland, Oregon   97223
Tel:  503-643-6999
Fax:  503-293-3507
Email:  bill@billparish.com

December 8, 2010

Curt G. Wilson
Associate Chief Counsel
Office of Passthroughs & Special Industries
Internal Revenue Service
1111 Constitution Avenue. N.W.
Washington, D.C.  20224

cc:    Douglas Shulman, Commissioner Internal Revenue Service
        William Wilkins, Chief Counsel, Internal Revenue Service
        Nancy Marks, Associate Chief Counsel, Tax Exempt Entities, Internal Revenue Service
        Karen Hawkins - Office of Professional Responsibility
        Media and Other Interested Parties

re:   American Bar Association Revenue Ruling request for Expansion of Exceptions Concerning Partnership Allocations Permitted Under Section 514(c)(9)(E),  the Fractions Rule, specifically, adding compensation to the list of items not applicable for fractions rule purposes,  and other proposed changes.

Dear Associate Chief Counsel Wilson,

For more than 15 years I have been a champion for sound corporate governance.   My work has been featured in front page stories in the NY Times, USA Today, Bloomberg and numerous other publications.  I also take great pride in being an SEC Registered Investment Advisor who leads key corporate governance efforts aimed at bolstering the overall system. 

Since 2004 I have been trying to raise the dialogue on private equity and hedge funds, in particular their interaction with public pensions.  Back then no one knew what a carry fee was.  These firms are now using tax exempt money to acquire businesses across all industries, including tax exempt hospitals, through leveraged transactions.  This includes companies ranging from Gymboree to GNC.

One might even ask whether these takeovers are creating a tax deduction pyramid scheme predicated upon transferring unusable tax deductions from tax exempt to taxable partners and effectively converting the companies acquired to tax exempt status, creating a dramatic drop in tax receipts, both at the corporate level and also the individual level due to post acquisition layoffs.

This could be a fabulous research project for an analyst at the IRS.  Simply pencil out the tax revenues for three years prior and subsequent to these takeovers.  You need only match the W-2 databases by employer and employee name and related info to capture layoffs, using a few standard attrition statistics, and then combine this information with the corporate side tax info.

The results of this analysis may provide good material for policy discussion and public debate.  Again, the whole purpose of the fractions rule was to prevent these senseless leveraged takeovers fueled by tax exempt investors.  This is not simply about UBIT related issues but also the fundamental notion of how these tax deductions are being allocated, i.e., do such allocations have substantial economic effect?

Based upon your panel comments at the 2010 Mid-Year Tax Section meeting of the ABA,  I believe the organization might be setting you up regarding the proposal to add compensation to the list of items not applicable for fractions rule purposes, and other proposed changes.   One might even question whether this effort by the attorneys involved is ethical given the stated attempt to foster legitimate business purposes, all the while downplaying the potential impact.  (See compensation discussion later in this letter.)

It seems clear that this revenue ruling request may be geared at private equity and hedge funds,  whose whole business model is not predicated upon owning assets but rather earning carry fees, i.e., compensation. 

Perhaps the reason these firms are pushing hard for the exemption and feeling anxious, as you noted in your talk, is potential concern over widespread non-compliance, in particular with respect to the allocation of compensation expense and related deductions between taxable and tax exempt investors.

It is similarly interesting that leading attorneys stress that “priority one for these partnerships is to obtain a comfort letter from your tax accountant regarding the allocations.”  My overall opinion, although I may clearly not be seeing all the pieces,  is that a significant amount of these allocations, putting aside the fractions rule, don't even meet the basic substantial economic effect standard that would allow them to use certain safe harbors for these basic expense allocations.

For example, when Blackstone put forth their partnership IPO, they recognized more than $20 billion in future compensation expense that would be amortized going forward.  The bulk of this cost are carry fees borne by tax exempt investors in its various partnerships.  This is effectively the key to their business model.  My point is that the compensation numbers for all these private equity and hedge funds are staggering. 

Therefore, if approved, this revenue ruling on IRC 514 (c)(9)(e) could introduce a level of gamesmanship involving the trading of tax deductions between tax exempt and taxable partners not seen since the 1980s.  Perhaps investors could once again be investing $1 to get $5 to $7 in tax deductions, creating a new economic dysfunction resulting from a poor allocation of resources.

What I also found most interesting about your ABA presentation at the 2010 Mid Year Conference is your comment that there do not appear to be any significant challenges by the service regarding whether or not these firms' taxable partners are taking deductions they are not entitled to.  Blackstone is perhaps a good example, based upon available SEC information, in which tax deductions from tax exempt entities appear to be flowing to taxable partners via the public entity and its tax receivable agreement, clearly in violation of both the fractions and substantial economic effect  (substance) rules. 

A  close friend, and superb retired tax lawyer,  noted that it was a brilliant group of lawyers at King & Spaulding that helped write the fractions rule in a way so that it had teeth.  Perhaps it is ironic that another brilliant lawyer at King & Spaulding, Wayne Pressgrove, may be a key voice in leading a sophisticated effort to gut it on behalf of his clients via the proposed revenue ruling IRC 514(c)(9)(e).  King and Spaulding's clients include the Carlyle Group and many other prominent private equity firms in addition to three of the top four public accounting firms.

I wrote a blog post for general audiences which focuses on Blackstone and outlines the basic parameters regarding this situation  http://billparish.wordpress.com/2010/08/27/blackstone/  The goal was to provide just enough detailed information to stimulate interest among journalists, analysts and leading academics.  This letter will be added to the post.

My hope again is that you will deny the ABA's revenue ruling request regarding IRC 514 (c)(9)(e) and begin aggressively enforcing the fractions rule and related rules regarding the allocation of tax deductions between tax exempt and taxable investors.  This would introduce more equity into the system and also result in significant new revenues for the service without needing to increase rates.

As an independent investment advisor, this would also make it easier to hold investments long term without worrying about such takeovers, in addition to maintaining clients who might otherwise suffer a senseless job loss.

Please don't hesitate to call or email if you would like to share some thoughts on this issue.  Thanks so much.

Respectfully,
Bill Parish