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*** March 31, 2011 *** Blackstones Tax Engineers, Inspired

by General Electric, Attempt to Repeal The FractionsRule

March 31, 2011 by Bill Parish

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,
specically designed to end this scheme. During this period no rm was more abusive with respect to
tax avoidance than General Electric. Today Reagans reform is being challenged in an assault on taxpayer
fairness led by the private equity rm Blackstone and its CEO SteveSchwarzman (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 nations leading real
estate attorneys. It is actually two short clips, the rst 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 Youngs real estate practice. The complete audio recordings for Presants remarks, in
addition to those of Internal Revenue Service Associate Chief Counsel Curt Wilson, can be purchased at
http://www.dcprovidersonline.com (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 rm, King & Spaulding, to craft the fractions rule in the 1980s, and these lawyers did brilliant
work.

Audio Clip 1 (0:25)

Hear Sanford Presant Introduction and Background
0:00 00:00
00:00

mp3 le (for iPad users) (https://billparish.les.wordpress.com/2011/03/presantintromp3.mp3)

Audio Clip 2 (1:26)

Hear Presant Enthusiastically Explain How Investors Received $5 of Tax Deductions for Each Dollar
Invested
0:00 00:00
00:00

mp3 le (for iPad users) (https://billparish.les.wordpress.com/2011/03/presantfractionsmp3.mp3)

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
0:00 00:00
00:00

mp3 le (for iPad users) (https://billparish.les.wordpress.com/2011/03/wilsonmp3.mp3)

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 Associations 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 departments February 2011 General Explanations of the
Administrations Fiscal Year 2012 Revenue Proposals (http://www.treas.gov/ofces/tax-
policy/library/greenbk12.pdf) were released and they include a repeal of the fractions rule (see page
90). Wilson now notes that someone else in his ofce 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 signicant prots, 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 ofcial.

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

Given the opaque nature of these tax schemes at rms 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 les its own 10K with the SEC. This provides valuable information including executive
non-qualied (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 Blackstones own 10K ling 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 Blackstones SEC lings and org
chart. It is mostly owned by tax-exempt public pensions. The carried interest fees these tax-exempt
pensions pay is indeed Blackstones primary source of income, an expense to the tax-exempt pensions
and revenue to Blackstone.
If Blackstone is manufacturing non-qualied (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 signicant 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 rms. 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 conrm 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 ndings 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 ow matters.

(https://billparish.les.wordpress.com/2011/03/catalentrollup1.png)

One could argue that the only real company in this whole structure is Catalent. Imagine how frustrated
their competitors who pay signicant 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, specically
with respect to compensation allocations, in my opinion.

Repealing the fractions rule is now the Holy Grail for many private equity rms, 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 ReagansPresidency, 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 rms 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 rms 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 prot 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 PaciCcorp 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 briey visit what
leading tax attorneys call the Mariana Trench of the Internal Revenue Code, that is the fractions rule,
scheduled to be repealed per Obamas 2012 revenue proposals. See link to blogpost titled Blackstone,
Private Equity or Public Theft,at http://www.billparish.com (http://www.billparish.com)
Recommendation: Have your top analyst take a look and conrm 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 efcient you are, and no matter how great the sloth at these PE rms, this will greatly impact
you in my opinion.

There are many specic 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 GPs like Blackstone and KKR from trading additional
partnership benets with tax exempts LPs 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 benets, 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 rms 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
ow basis with rms 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 wont effect us Bill, do have one of your best analysts take a good took. Quite
remarkable. Ive 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 (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 ofce 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, specically 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 ofce but I cant get a response from him who this is, much less any
specics.
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 rms are making very
signicant revenues servicing private equity and hedge funds who aggressively use carry fees. I began
my career at Arthur Anderson when it was a great rm in 1980s. Perhaps helping prevent this repeal
will also help prevent an Anderson like moment in the future for one of these rms. It is indeed possible
that this is a bigger situation than LILO leasing.

Best regards.

Bill Parish

Posted in Uncategorized | Tagged blackstone, fractions rule, irs, King & Spaulding, net operating loss,
Private Equity, Sanford Presant, steve schwarzman, tax, volcker, Wayne Pressgrove |

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