As early as next week, the Obama administration is expected to unveil plans to dismantle parts of the U.S. Securities and Exchange Commission in a regulatory reorganization. A proposal, still believed by many to be in draft form, is rumored to reallocate regulatory supervision of the financial titans — those institutions deemed too large to fail — to the Federal Reserve. Other items expected to be stripped from SEC oversight include consumer finance products such as mutual funds. A regulatory reorganization is premature and inconsistent with other actions taken on Capital Hill.

On February 26, 2009, the Obama administration announced plans to boost the SEC’s budget by 13%. The SEC has been underfinanced for almost two decades and as a result, understaffed. It will take time to both hire and train new staff even after the new budget goes into effect in fiscal 2010. Nonetheless, the economic crisis was not a function of the gaffe involving Madoff. The economic crisis is a result, in part, of the real estate bubble, caused by exceptionally long periods of low interest rates, a decision driven by the Federal Reserve.

Another culprit, Fannie Mae and Freddie Mac — thank you Congress. Sorry, but everyone does not deserve to own a home. If you cannot afford to pay for it, don’t buy it. If you’re a lender and they cannot afford to pay for it, don’t extend credit. Our economy was drunk on the American consumer’s excess and we are now experiencing the hangover. Point is, there is no regulatory agency nor are any of our elected officials without blood on their hands. Each has contributed to the economic crisis. The SEC has a long history of and experience in monitoring and prosecuting the financial industry. Over the next 12 months the SEC will continue to dramatically recreate and improve itself as the budget increases allow the SEC to hire and train new staff and the new Chairwoman, Mary Schapiro continues to implement her plan. We all want the economy to improve, but recognize that haste makes waste. Allow the budget to kick in and provide the Chairwoman the opportunity to do her job.

Tags: Bernard Madoff, Fannie Mae, Federal Reserve System, Freddie Mac, Mary Schapiro, SEC, U.S. Securities and Exchange Commission

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By Steven M. Etkind and Roger D. Lorence

The Treasury Department has released its lengthy explanation of the President’s wide-ranging tax proposals.  The President aims to deliver on both tax “fairness,” especially the ending of perceived tax abuses and “loopholes,” and increasing federal tax revenues.  Particularly hard hit would be U.S. businesses with operations outside the U.S. and the financial services sector. Because of the very large number and diversity of the President’s proposals, we outline below only those of most interest to the financial services industry.  If the entire package were to be enacted, this would be one of the most sweeping revisions to the tax law since the enactment of the Internal Revenue Code of 1986.

Repeal of the Carried Interest

Under current law, the manager of a domestic partnership may receive an incentive allocation of partnership profits which is treated as a share of the various income components realized by the partnership that taxable year.  This special allocation of profit is termed the “carried interest” and has been a major spur to development in the oil and gas, real estate and investment fund industries.   The President proposes to repeal the carried interest rules for taxable years beginning after December 31, 2010.  The carried interest would be taxed as “services partnership interest” income that would be ordinary income, whatever the character of income generated by the partnership, and would be subject to self-employment taxes.  Only a manager’s profits on their own capital interest in the partnership would be exempt from these rules. Individuals performing services holding derivatives instruments in that entity would also be subject to ordinary income treatment with respect to the derivative interest.  If enacted, this would likely reduce the “mini-master” structure of offshore hedge funds which are structured to claim the benefits of the carried interest.

Commodities Dealers:  Partial Repeal of Section 1256

Current law treats U.S. persons who are dealers in commodities, equity options, and commodity derivatives as generally entitled to treatment under Section 1256 of the tax law whereby 60% of gain or loss is long-term capital gain and 40% is short-term capital gain (for so-called “60/40″ contracts).  The favorable 60/40 treatment (currently a blended maximum rate of 23% for gains) is, the President contends, unwarranted, particularly compared to tax treatment of other types of dealers, whose gains and losses are ordinary income.   The President proposes that dealer income of commodities dealers, including dealers in equity options, be taxable as ordinary income, effective for taxable years beginning after the date of enactment.

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Tags: Financial services, Income tax, Internal Revenue Code, Internal Revenue Service, tax, Tax forms in the United States, United States, US$

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By Steven M. Etkind, Roger D. Lorence and Steven Huttler

The Internal Revenue Service (the “IRS”) has issued two rulings on participants in the life settlements industry.  This ever-expanding investment strategy entails the sale of life insurance policies to third party investors, who may themselves re-sell the policies or hold them to maturity (the death of the insured).  The life settlements industry has grown from a small “niche” market to a major international market where billions of dollars of capital are invested.  Both rulings are “revenue rulings,” which are rulings of general applicability and a high level of authority, albeit not as authoritative as regulations.

Taxation of the Insured

In Revenue Ruling 2009-13, the IRS analyzes three fact patterns in which the insured neither received distributions nor took out policy loans against the policy, which in the first two scenarios has a cash surrender value and in the third case has no cash value.

In the first case, an individual enters into a life insurance contract, which he surrenders for its cash value.  The policyholder paid total premiums of $64,000, and received $78,000 on surrender.  The IRS ruled that the $14,000 gain is ordinary because the surrender was not a sale or exchange of the policy (which is required to trigger recognition of capital gain or loss).

In the second scenario, the dollar values were similar to those of the first case, except that the individual sold the policy to a third party.  The sales price was $80,000.  The IRS ruled that the insured’s adjusted tax basis in the contract must be decreased by the cost of insurance (here, $10,000) during the time the policy was outstanding.  The IRS further ruled that the difference between the cash surrender value at the time of the sale ($78,000) and the policy holder’s adjusted tax basis ($54,000, which was the total premiums paid of $64,000 less the $10,000 cost of insurance) is ordinary income.  This prong of the ruling was based on case law holding that the “inside buildup” (increase in policy value due to investment of premiums in excess of the cost of insurance and related charges) represented investment income, analogous to a dividend on stock or interest on a bond.  After applying this “substitute for ordinary income” rule, only the excess of the sales proceeds above the cash surrender value was treated as long-term capital gain.

The facts of the third scenario differ from those of the first two because in the last case the policy had no cash value.  This case involved the sale of a 15 year level – premium policy with a $500 monthly premium.  The policyholder sold the contract to a third party during the fifteenth year of the policy for $20,000.  The ruling holds that the gain on sale is all long-term capital gain, except for one-half of the last-month’s premium, which represented the policyholder’s tax basis.

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