House Backs Tax Increase for Venture Capital | Hacker News Reader

House Backs Tax Increase for Venture Capital

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29 pointsjlhamilton13 comments

VCs have a special stake in this particular debate and find themselves in the minority in an environment when everyone is howling for the heads of all those who manage private equity funds. And "carried interest" does indeed represent a type of gain that probably can be fairly classified as being (1) attributable to the sale of a capital asset and hence eligible for capital gains treatment or (2) attributable to services performed by a GP in managing a fund and not tied in any significant way to capital actually invested by that GP in the asset being sold.

This Congress says the tax is for services rendered and should be paid at ordinary income tax rates (actually, 75% of carried interest will be taxed as ordinary income and 25% as capital gains - and there will be a phase-in to boot, so that the full impact will not hit the VCs for some years). Prior Congresses have disagreed.

Make no mistake, though, that the issue here is not one of merely closing a loophole. This Congress believes philosophically in raising taxes to pay for its expansive spending proclivities, and it is looking to do that in more ways than one. VCs happen to be a big, fat, and unpopular target in this instance. Private entrepreneurs will be next.

For this reason, among other things, this Congress will make sure that it does nothing to block the automatic increases scheduled to go into effect January 1, 2011 (LTCG from 15% to 20% and top bracket on ordinary income from 35% to 39.6%).

Now, any one of us may or may not be bothered by this depending on our particular view of the role of government, the importance of a social safety net, and the part taxes should play in funding these social aims. Indeed, we may see these developments as a positive good in changing the balance between government and private enterprise. That is basically a political and philosophical issue.

But do realize that this sort of expansive view of taxation, as applied here to the VC's "carried interest" gains, could just as easily be applied to founders who put no (or trivial) cash into a company up front and yet profit from the ultimate sale of equity that they get up front as they found their companies and then devote years of service to building its value. While it might be shocking to contemplate, if one were philosophically inclined to do so, there is nothing stopping a future Congress from saying - based on a direct analogy to the logic being applied here to carried-interest taxation - that the gains of such founders are really more attributable to their services than to any capital investment and hence should be taxed at ordinary-income tax rates (or maybe at some hybrid rate such as being applied here to the VCs, such as 75% at ordinary income tax rates and 25% at LTCG rates). In this sense, startup founders typically are no more investing "capital" for their stock than a GP is investing capital for its "carried interest" share.

I realize there is no risk of this type posed anytime soon to founders. But, logically, there is little difference between the two cases and what is regarded as the founder's perk of today might, with passage of time and a new political environment, just as easily become the "loophole" of tomorrow.

If I understand this correctly, the loophole that's being closed here is a special tax rate for "investment income" from money that did not expose the VC's themselves to risk, but only the VC's limited partners (who provide most of the capital for venture funds).

In other words, the pension funds, endowments, and corporations that actually provide capital aren't being taxed more aggressively. The people who allocate that capital are.

This makes sense, doesn't it? If you invest $10,000 of your own money in a company for several years, you should rightly expect to pay the long-term capital gains rate on the returns. The tax code wants to encourage you to invest in things and drive the economy, and you did that.

But if I give you $10,000,000 to invest for me, and you turn it into $50,000,000, you shouldn't be getting a free ride on the millions of dollars you just made. The money was getting invested one way or the other. All you did was make it your job to invest it (allegedly!) efficiently.

Every single GP will admit it's a total giveaway when they're drinking and amongst their kind. How do I know? I've been drinking with many in my time as an investment banker, junior VC employee, and "trusted" entrepreneur.

You know what's worse? The PE guys and the hedge fund managers get this treatment on carried interest too, but they know there's absolutely no way to justify it and so they're letting the NVCA stick up for all of them. There are massive amounts of money being funneled by members of the Private Equity Council into this debate that no one is seeing.

Hedge fund incentive fees are taxed as ordinary income.

That's correct. VC firms are structured as partnerships, rather than regular corporations with employees, specifically so that general partners can be compensated using "carried interest" which receives this favorable tax treatment.

This change would not have any effect on the decision of investors to invest their money into VCs, as far as I can tell. This would simply remove a tax subsidy on money managers, both in the VC industry and in other activities like hedge fund management. I wish all these people well, but don't see any policy reason they should pay a lower tax rate than the rest of us.

VCs are already investing more of their capital off-shore, this bill would further discourage them from investing in US startups.

As others have pointed out, this has little to do with the capital itself, but with the compensation that VCs get essentially as money managers. So the impact on actual investment is likely to be close to zero, even if there are reduced incentives to being a VC. Look at it this way - if a plague struck and killed one of every 10 VCs, chances are that the amount of capital wouldn't radically change - it would just mostly get reallocated among the survivors (I'm sure it would change in some marginal case, it might depend a bit on who the affected VCs were, etc.)

boy, do we need tax simplification. all of this micromanagement of our lives isn't sustainable.

I doubt if anybody could determine the total cost to the economy. Of course, costs aren't anything lawmakers are concerned with.

It would simplify the tax code not to carve out special exemptions for venture capitalists.

“It is both ironic and disconcerting that legislators can profess commitment to creating jobs — and then discourage the type of long-term investment which has been a proven job creator for the last century,”

.. this is only true if you can show that VCs create more jobs than an alternative investment of the same capital. Is there any data on this?

Probably not, but there's rumblings about the poor relative performance of VC as an asset class in general (ie in returns relative to illiquidity) --- and investment in, say, corporate bonds also funds business expansion.

Anyone interested in reading more about this should check out this paper that was fairly central in advancing the debate over the last four years. It's an interesting read, and highlights some of the challenges with matching tax policy to desired outcomes. http://victorfleischer.com/archives/80

Also, this is an interesting blog archive from when the author of that paper was a regular contributor, as the debate picked up in 2006-2007: http://www.theconglomerate.org/taxation/page/3/

It's about time. There's nothing like a fiscal crisis to get a few tax loopholes closed.

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