I should start by saying that because of the idiosyncratic nature of my thirteen years of venture investing, I’ve never been paid a carry. And, since I’m now a country gentleman, cutting the brush and tending the horses over here in bucolic Hoboken, I probably never will be. So maybe I’m uniquely qualified to give an opinion on the carried interest taxation issue, being neither fish nor fowl.
That is to say, I don’t have an interest in how this turns out. But I do happen to dislike the political circus, the populist sop that our leaders trot out to convince us they are actually solving problems when all they’re really doing is nothing.
Fred Wilson says, “someone has to pay the taxes to keep our troops equipped, our borders secured, our schools modernized, and our children healthy. It might as well be me and my wife.”* So why do I think taxing carried interest as earned income instead of capital gains does precisely nothing?
The tax code has a certain mathematical beauty that rebels against the alchemy of turning capital gains into labor income just by decreeing it. So, while we could tax Fred on his carry at ordinary income tax rates, this would not, unless a whole lot else was changed, increase the revenue of the US Government by much, if at all.
Why? Because if Fred’s firm paid him a salary instead of a cut of the gains, he would pay ordinary income tax rates on it sure, but (since VC firms are pass-through entities) it would be deductible to the firm’s owners, the LPs**. To understand this you have to know how an LLC (or any “pass-through” entity) works. The LLC, when it has income or losses, reports them to its owners and the owners report their share as income or loss on their own tax returns. The LLC pays no tax, its owners pay all the tax. Also, the LLC does not just send a net profit number to its owners as the taxable amount, it sends a report of each item–ordinary income, capital gains, interest, ordinary expenses, etc.–and the owners slot each item into the appropriate spot on their own tax return.
So if a VC fund had a $100 gain, it reports now an $80 cap gain to its owners and a $20 cap gain to the people running it. The total tax take is $100 times the capital gains rate. If carried interest were considered ordinary income (i.e. salary), the fund would now report $100 in capital gains to its owners, a $20 salary to the people running it and, note this!, a $20 ordinary loss to its owners. Total tax take would be to first approximation capital gains rate times $100 plus ordinary income tax rate times $20 minus ordinary income tax rate times $20. For you ad folk who haven’t done algebra since 11th grade, that equals exactly the amount being taken by the government now.
Of course, in this example, Fred pays more, but his LPs, big financial institutions and wealthy individuals in many cases, pay less. The VCs pay more and the the Money pays less.
If this is a question of fairness, as Paul Kedrosky implies, then let’s talk about fairness***. Here’s a scenario:
I start a company. I own all of it, since I started it. I raise $20 million in participating preferred with a ten-year redemption right at a $5 million pre. I now own 20% of the converted equity in the company. I use the $20 million to invest in other startups. Voila, I am a venture fund.
Simply by starting a company I have the same economic and tax characteristics as a venture fund, without any mention of a carried interest. In this sense VC funds are like any other startup. This illustrates that the same fairness argument being applied to VCs applies to entrepreneurs. Founders and VCs don’t invest capital in their ventures but they both pay capital gains. No capital at risk, no capital gains treatment? If that’s “fair” for VCs then it must be for founders, right? Be careful what you wish for.
To be clear, neither founders nor VCs “deserve” capital gains treatment. Neither founder’s equity returns nor carried interest is a gain on capital, both are gains from labor****. Our society has tolerated treating these as capital gains because we want to encourage the activities. Personally, I think we should encourage both entrepreneurship and venture investing. Especially if it’s merely a question of deciding how the same amount of taxes paid should be distributed between the VCs spending their not-especially remunerative lives***** trying to help people start companies and the Money that they’re investing for.
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* As an aside, I think we could pay more for the two of these I support by cutting the two I don’t. But that’s neither here nor there in this argument.
** And noting that many LPs are tax-exempt does nothing for me. In this case, where talent and not money is the scarce resource, I believe the tax incidence will fall on the owners of the firm, not the people running it. This is probably the source of the juggle of who pays what in the first place.
*** Which is a fuzzy thing to talk about anyway. The only cogent philosophical arguments for levels of taxation I have ever heard are exemplified by Nozick
**** Why does capital get treated better than labor anyway? Not because, as Fred avers, it deserves it. Rather, it gets better treatment because it’s more mobile. Higher rates here than in Bermuda? Money moves to Bermuda. Higher ordinary income rates here than in Russia? People don’t move because of that (unless you’re extremely wealthy.)
***** See point 6.
A very smart friend said he read the post but lost interest about halfway through. Fair enough. Here’s what I said:
1) Not all labor is taxed as labor. Carried interest is one example, but there are others, like founder’s stock. It is certainly inconsistent, but saying it is ‘unfair’ is a moral judgement.
2) Taxing carried interest will not raise more money for the US government. It will simply transfer the tax burden from the investors in venture funds to the venture capitalists. This is a bit less exciting and, really, who cares? Personally, I would rather see VCs better compensated and the institutions that invest in them less well compensated, but that’s an opinion based on who my friends are.
I would be willing to bet, in fact, that if this tax is passed that the standard contract is changed to make it moot. If, in a few years, carried interest is typically 25% instead of 20% and LPs are more often for-profit entities and not NFPs, then I will declare myself right.