The balance of this blog consists of a revision that I have just made to my Federal Tax Procedure book as a substitution for the discussion of Revenue Procedures at Ch. 2 II.B.6.d. (beginning on p. 52 of footnoted version and p. 35 of nonfootnoted version). Please note that the footnote numbers are interim from the draft for the next edition.
(2) Revenue Procedures.
Revenue Procedures are IRS publications advising the public of internal management and procedural matters. They thus differ from Revenue Rulings which advise the public of IRS substantive law positions. n170 For example, the IRS uses Revenue Procedures to advise the public about detailed requirements for requests for private letter rulings (discussed immediately below). In this sense, they act as “check lists” that taxpayers and practitioners follow in order to seek private letter rulings. Like Revenue Rulings, Revenue Procedures are published in the Internal Revenue Bulletins and Cumulative Bulletins.
There can be some confusion in some limited cases as to how the Revenue Rulings intersect with substantive interpretation of the law. I illustrate the potential for confusion in one area of the substantive law that periodically comes up as an anomaly in IRS practice. The substantive issue is whether and how so-called partnership “profits interests” – sometimes in some contexts called “carried interests” n171 – received for services are taxed – if taxed, when taxed (upon “receipt” or later) and how taxed (ordinary income or capital gain). The bottom line is that persons who provide services in return for such profits interests do not want them to be taxed upon receipt and, when taxed later upon some subsequent taxable event, do want them to qualify for capital gains treatment. n172 The competing tax imperatives are that service income be taxed as ordinary income and return on the investment of capital (as opposed to services) be taxed as capital gain. Which of these imperatives should prevail in the case of profits interest may be uncertain but the sparse case authority raises at least the strong possibility that ordinary income treatment should apply. n173 But, powerful and influential forces in the economy want capital gains treatment to prevail. The IRS has issued proposed Regulations that would tax these interests under Section 83, but has not finalized those Proposed Regulations. n174 Before issuing the Proposed Regulations, the IRS issued two Revenue Procedures, still effective, that tell agents what to do when auditing such transactions; those Revenue Procedures went a long way toward giving the receipt of profits interests capital gains treatment. n175 In effect, those Revenue Procedures, while not interpreting the law, instruct agents not to raise the ordinary service income issue in all except the most blatant of cases. This is thus just a procedural management rule rather than an interpretation of the law, but the rule does have the effect of exempting many profits interests from audit, thus potentially giving a huge substantive tax benefit to a very lucrative and politically powerful industry. By exempting these profits interests from audit, these profits interests receive capital gains treatment without being tested under the substantive law. n176 For this reason, large swaths of the “industry” receiving the largess of these Revenue Procedures have interpreted them as IRS approval of the legal interpretation they desire – capital gains treatment for what is nothing more or less than service income. n177 At the end of the day, however, the Revenue Procedures are not interpretations of the statute but simply guidance to agents as to when not to raise the issue. This is an internal management function, not an interpretation of the law and confers no rights on taxpayers other than, perhaps, the expectation that auditing agents will follow the internal management procedures while the Revenue Procedures are outstanding. The point for present purposes is that Revenue Procedures do not serve as interpretations of law but just of practice and procedure within the IRS.
Footnotes to the foregoing text
n170 Rogovin & Korb, pp. 336-337; see Reg. 601.601(d)(2)(vi). [The Rogovin & Korb article is: Mitchell Rogovin and Donald L. Korb, The Four R's Revisited: Regulations, Rulings, Reliance and Retroactivity in the 21st Century: A View from Within, 46 Duq. L. Rev. 323 (2008).]
n171 I think the term “carried interests” hearkens back to oil and gas tax law. The IRM defines carried interest as (IRM 18.104.22.168.4.6.4 (10-01-2005)):
The term "carried interest" generally refers to an arrangement where one co-owner of an operating interest (the " carrying party" ) incurs an obligation to pay all of the cost to develop and operate a mineral property, in exchange for a right to recoup this investment out of the proceeds from the first production form the property. After the investment is repaid, any subsequent production is split between the co-owners. The co-owner(s) not obligated to pay for the development and operation hold a carried interest in the mineral property until the carrying party's initial investment is repaid.
Beyond the oil and gas context, for example, in an investment type fund (hedge or private equity), it means an interest payable only from the profits of the venture without the burden of capital or operating costs to produce the profits. The carried interest is thus like the oil and gas carried interest. The key difference for these types of funds is that the investment fund carried interest is an interest received for the managers services in producing the profits.
n172 A lot of arguments back and forth about the nuances of the issue has been spilled. I cannot cite all of the many, many articles on the subject, but will just cite a couple that I think are fairly representative of the best articles. Victor Fleischer, Two and Twenty: Taxing Partnership Profits in Private Equity Funds, 83 N.Y.U.L. Rev. 1 (2008); David A. Weisbach, The Taxation of Carried Interests in Private Equity, 94 Va. L. Rev. 715 (2008); and Philip F. Postlethwaite, The Taxation of Compensatory Profits Interests: The Bind Men and the Elephant, 29 NW J. Int'l L. & Bus. 763 (2009).
n173 See Diamond v. Commissioner, 56 T.C. 530 (1971), aff'd, 492 F.2d 286 (7th Cir. 1974); and Campbell v. Commissioner, T.C.M. 1990-236, rev'd, 943 F.2d 815 (8th Cir. 1991).
n174 The notice of proposed rule making appears in IRB 2005-24, dated June 13 2005, which is on the web here: http://www.irs.gov/irb/2005-24_IRB/ar15.html.
n175 Rev. Proc. 93-27, 1993-2 C.B. 343; and Rev. Proc. 2001-43, 2001-2 C.B. 191.
n176 When and if the IRS finalizes regulations on the subject, the Revenue Procedures will be revoked or revised to be consistent with the substantive law thus determined. Indeed, in the Proposed Regulations I mention above, one conforming adjustment contemplated the revocation of these Revenue Procedures.
n177 One might say that their interpretation of the law creates an entitlement to which they are, well, entitled.Addendum: I should note that promoters of the notion that profits interests to service partners should not be taxable as ordinary income have been wishful thinking about the law for a very long time. I handled the Diamond case, here, for DOJ Tax Appellate, the first and leading case on the issue. In that case, the taxpayer argued along with the industry favorable pundits that the Regulations which required taxation of a capital interest for services created a negative inference that a profits interest for services would not be taxable and therefore that should be the law. The Tax Court and the Seventh Circuit disabused them of that notion. Now, of course, broader and different industry groups are arguing much the same -- that the IRS's Revenue Procedures somehow interprets the law their way. They are wrong, of course, but as the old saying goes, a lie repeated long enough will become the truth if it is not challenged. But, of course, in our system when that lie is challenged, it will be found not to be the truth because courts will recognize that long-held falsehoods don't make them true. Just my opinion. And, of course, if the truth is other than as the industry claims, the IRS has literally left billions and billions on the table through inaction and thereby contributed mightily to the growth of both the deficit and the 1% (or some other low percentage) and the increasing inequality in America (which are, of course, fellow travelers, a term well known to my generation). I say shame on the IRS. In my view, it will not do to say the Congress could have addressed the problem and failed to do so. At least since Chevron was decided (predated the proposed regs), the IRS has had ample reason to believe and act upon the belief that it could fix the problem consistent with the general notion that service income is not capital gains in whatever guise service income may appear. Shame on the IRS for not fixing the problem. Shame on Congress as well for not fixing the problem. And shame on the many practitioners who exploited the IRS's inaction when they should have known better. That genre of thinking is no less objectionable when it is wrapped in Son-of-Boss or some other abusive tax shelter than it is when it is wrapped in seemingly esoteric notions of carried interests and profits interests. Service income is service income and should be taxed as such under the Code constructs. What a tragedy. And these people who benefited from this IRS inaction / largess have the gall to say that they paid no less tax than the law required. They did pay less tax than the law required; it is just that their buddies at the IRS did not insist upon them doing so. But, then again, that does not excuse the behavior of taxpayers who exploited what they could get away with because of IRS inaction. We only imagine that we have a voluntary self assessment system when this type of behavior can be condoned and even claimed as a patriotic duty by a presidential candidate. I dare say that most good practitioners would have told those taxpayers two things: (1) it is more likely than not that carried interests in return for services do not qualify for capital gains treatment and (2) you can get away with it because the IRS is not insisting that you pay the taxes that it is more likely than not that you owe. Maybe those practitioners would not have worded it precisely that way (not many taxpayers will pay for negative advice that is the unmitigated truth), but if they were good practitioners they would have known that those were truisms. Now, as to the ethics of the taxpayer claiming the benefits after receiving the gravamen of that advice, I will let the readers make their own decision and I do hope that readers will comment according to their beliefs. But, remember that the Son-of-Boss and Cousins-of-Boss in spirit believed the same thing while they raided the fisc.
Now, I made a statement in the prior paragraph that good practitioners would recognize that it is more likely than not that, from a legal perspective, profits interests for services do not qualify for capital gains treatment. This means that they get taxed at some point as ordinary service income. I am sure that a lot of practitioners will find this statement incorrect, but I think as noted above that they are reading too much into the Revenue Procedures. I have addressed that position above. I do recognize that scholars see this differently. Compare, Victor Fleischer, Two and Twenty: Taxing Partnership Profits in Private Equity Funds, 83 N.Y.U.L. Rev. 1, 16 (2008) ("Despite a couple of hiccups in the doctrine - the Diamond and Campbell cases familiar to partnership tax jocks - it is well-settled law that the grant of a profits interest in a partnership does not immediately give rise to taxable income."); with Howard E. Abrams, The Carried Interest Catastrophe, 128 Tax Notes 523 (Aug. 2, 2010) (Describing the circular flow of cash construct that requires immediate taxation for receipt of a profits interest by a service partner, "every court to address the issue has held that the contribution of services to a partnership should be taxed in that manner," citing Diamand and the subsequent cases.). But the case authority, as opposed to internal IRS management determinations of dubious value as interpretations of the law, appears to be the best authority as to what the law requires. So I stand on the proposition that a good practitioner would conclude that the law, as interpreted (rather than managed), does require taxation (at least on a more likely than not basis), but you can get away with capital gains treatment because, in effect, no one is watching the store.
Now, there are of course some complications in the taxation paradigm. The profits / carried interest in a complex partnership designed to span over a significant period of time and assuming the continuing ongoing services of the partner to bring the future value to the profits / carried interest is very difficult to value on the front end. I would apply the tax common law open transaction approach to say that when that profits interests turns to value (e.g., sold or value is taken out of the profits interest or perhaps when it vests with no requirement or expectation of future services). This will insure that the service component gets taxed before turning the future "profit" after that event into capital that qualifies for capital gains treatment. This is perhaps not a perfect solution -- most tax solutions are not perfect solutions -- but what it does do is to balance the service / capital distinction in a way that insures that the service income gets taxed as ordinary income at an appropriate and fair time.
For other articles on the substantive issue of whether return for service should be able to metamorphose into capital gain, see:
More Tax Tricks, Private Equity Style (NYT Editorial 9/5/12), here.
Wikipedia entry on Carried Interests, here.
Addendum 9/29/12: I have just revised my Federal Tax Procedure text (draft for next edition) to address deference for Revenue Rulings and Revenue Procedures:
Let’s go back to Revenue Rulings? In the usual context where the taxpayer seeks to avoid the application of a Revenue Ruling and the IRS seeks to apply it, courts have adopted varying approaches. Let’s address that issue under the Chevron/Mead approach. Are Revenue Rulings entitled to Chevron deference? It is true that they are not subject to notice and comment, the hallmark of the traditional regulation. But a regulation is not required for Chevron deference. Can it be said as to Revenue Rulings, as the Court said in Mead, that: “It is difficult, in fact, to see in the agency practice itself any indication that Customs ever set out with a lawmaking pretense in mind when it undertook to make classifications like these?” Certainly, the IRS does provide guidance via Revenue Rulings. On the other hand, in issuing Revenue Rulings, the IRS purports only to state its position with respect to the assumed fact pattern and does not purport to be issuing an interpretation binding on taxpayers. Should therefore only Skidmore deference apply? I think it is a close case that can ultimately go either way, although the tilt now seems to be in favor of the more limited Skidmore deference.
For that reason (at least I suppose), DOJ Tax has announced that it will not assert Chevron deference for Revenue Rulings. fn245 It logically follows that the IRS will not assert Chevron deference for lesser authority IRS pronouncements (such as PLRs and other written determinations). Practitioners should not be lulled, however, because there are other forms of deference – particularly Skidmore deference – that could apply even though those forms of deference are less authoritative than Chevron. Let’s consider Revenue Rulings and Revenue Procedures, the most formal forms of pronouncement short of Regulations. Here is my best cut to date as to the deference rules based on the assumption that Revenue Rulings and, by extension, Revenue Procedures are not entitled to full bore Chevron deference:
Substantive interpretations of the law in Revenue Rulings should receive Skidmore deference. Procedural rules in Revenue Procedures should be given at least Skidmore deference and perhaps even Chevron deference; substantive interpretations of the statute stated or assumed in Revenue Procedures should be given Skidmore deference. fn246
For lesser forms of IRS pronouncements, Chevron will clearly not apply, but the Courts will have to address the issue of Skidmore deference. Of course, keep in mind that Skidmore deference is only available if the reasoning is stated in the pronouncement and the reasoning is persuasive. If the interpretation in such lesser rulings provides no reasoning, the IRS can always assert in the subsequent context in which it arises and presumably if the newly asserted reasons are persuasive, they have a good chance of carrying the day.
fn245 Marie Sapirie, DOJ Won't Push Chevron Deference for Revenue Rulings, 2011 TNT 90-7 (5/16/11).--------------------------
fn246 See Exxon Mobil Corp. v. Commissioner, 689 F.3d 191, 200 (2d Cir. 2012) (joining other courts rejecting Skidmore deference for a Revenue Procedure applying the interest netting statute that incorporate a substantive interpretation of the statute to require that both periods of limitation be open for netting; Skidmore was rejected not because Skidmore could or should not apply to such a substantive interpretation in a Revenue Procedure but because the Revenue Procedure stated no reasoning for the interpretation; Skidmore requires reasoning for deference). See also Kathryn Sedo and Katrina Wessbecker, Should Courts Ever Give Deference to Revenue Procedures?, 134 Tax Notes 225 (Jan. 9, 2012) (arguing that Skidmore deference rather than Chevron deference is more appropriate for revenue procedures, particularly those that may state substantive rules). For an illustration of Revenue Procedures that some have interpreted as stating an interpretation of the law as opposed to just providing agent guidance as to when to raise the issue, see my Federal Tax Procedure Blog entry, Are Revenue Procedures Influential In Interpreting the Law: Of Profits / Carried Interests and Administrative Billion Dollar Largess (9/7/12).
Now, what does this say about the Revenue Procedures for profits interests. Should they be given Skidmore deference as an interpretation of the law or are they simply intended as guides to agents. I think not, because the IRS was not intending to state the law as opposed to just guidance on administrative forebearance.