Dilution vs. Risk taking: Capital gains taxes and entrepreneurs | Hacker News Reader

Dilution vs. Risk taking: Capital gains taxes and entrepreneurs

nber.org

56 pointshhs73 comments

The paper spots that this pseudo-wealth tax would be better for more founders.

> Moving from current realization-based to accrual-based taxation would reduce founder ownership at exit by 25% on average but would also increase the fraction receiving positive payoffs from 16% to 47% when tax credits are refunded.

Founders would use VC money to pay the tax and get a refund if the startup fails, since the capital gains were never realized. Therefore "pre-paying" capital gains would be a good thing for most founders since otherwise a liquidity event wouldn't happen for 84% of them.

This only happens with a tax on unrealized capital gains, though, not a normal wealth tax.

Another corollary is that "zombie startups" would be heavily discouraged, since "failing fast" could result in a payout.

It is basically forcing them to dilute more, which is better for them on average because the shares expire worthless so often anyway.

That said a higher percentage of positive outcomes does not mean much when the majority of significant wealth is in that small percentage of high value firms founded.

> It is basically forcing them to dilute more, which is better for them on average because the shares expire worthless so often anyway.

Well no, because VCs might not give you money to buy chunks of the business as they want the money to go into the business.

An unrealized capital gains tax forces VCs to give founders money during funding rounds to cover taxes, money that is refunded to the founder in the event of the business going under.

This means you no longer lose everything in an unsuccessful exit, because you get a refund on the capital gains that you didn't end up having.

This is assuming no reaction from people to this tax going into effect. And that's of course stupid. This is trivial to game and for that reason it will rapidly turn into a money pit for the tax agency.

After all, it's real easy for entrepreneurs to be unsuccessful. You get some nonzero valuation by having a friend bid or give some investment and thereby set the valuation, and then you go bankrupt.

The money comes from investors, goes to the tax agency, and comes back again. (Or maybe it doesn’t if it’s just a credit towards future taxes?)

This scheme depends on winning the trust of investors and then defrauding them. Sure, it can be done, but there are other ways. The simplest would be paying yourself a higher salary.

Presumably, investors are aware of the risks and are willing to take them.

You still have to pay the tax in the first place to go bankrupt.

No, someone else has to pay the tax in the first place. Am I reading it wrong?

That's how progressive taxes work? It's generally considered a better outcome when the taxes are paid by people who can more easily afford them.

Sounds like when I have a major tax bill, me and some friends should found a startup with poor prospects for success

Whoever plays the part of the investor would be paying your taxes. It might be difficult to get someone to do that?

Doesn't seem fair to tax someone on appreciated stock if they haven't sold and haven't taken any loans against it.

Yeah I'm in favor of leverage == taxable event. I think the meaningful difference between leveraged and unleveraged capital gains is that when you take a loan, you access liquidity via your ownership in the asset. If you had gotten a dividend, that would have been taxable. A loan with a stock backing it isn't the same thing, but it does have a somewhat similar effect.

You still need to pay off that loan eventually though.

These asset backed loans are just regular loans with lower interest rates. So instead of getting $50M @ 11% they can get it at 4%. That's the extent of the "hack".

They then keep the ball rolling by refinancing at each expiry and just paying the interest (and hoping their assets maintain or increase in value)

Eventually those loans will need to be repaid and the money will need to come from realizing capital gains.

So if anything its a tax deferral scheme with a low interest rate and elevated liquidation risk. Which all raises the issue of being taxed twice on the same money. Taxes once when you take the loan against it, and taxed again when you realize the profit to pay the loan.

The trick is that the USA steps up the buy price of an asset when you pass away. So if you use cheap loans your whole life, you can defer capital tax until it goes away.

Instead of two certainties in life being death and taxes, it's now death or taxes.

I have to congratulate you on the quip at the end there, which I'll steal! Great way to summarise this strategy. Is it an ENGNR original?

Lol thank you. Original as far as I know, most welcome to steal!

Look up "buy, borrow, die" tax strategy for an explanation on how taking out a loan secured by appreciating assets can reduce your tax bill.

Eventually those loans will need to be repaid and the money will need to come from realizing capital gains.

Uh, yes. But they can be repaid with refinanced loans based on the same assets... So no guarantee that the gains will be realized. And in the possibly long interim between loan issuance and maturity, the owner accesses liquidity via the asset and pays nothing in taxes.

Which all raises the issue of being taxed twice on the same money. Taxes once when you take the loan against it, and taxed again when you realize the profit to pay the loan.

To clarify, I advocate that the loan issuance be a taxable event, where the cost basis of the shares are adjusted to the current price of the asset. So there would be no double taxation.

I think it is useful to point out that the conditions under which those loans make any sense are incredibly narrow. It is far from the norm because it doesn’t pencil out in pure financial math. Wealthy people are not stupid, and the notion that this is being widely used as a tax avoidance measure tacitly makes that assumption. Studies seem to indicate that the prevalence is so low as to round to zero. There are many practical reasons to do it at the margin as a cashflow management exercise but not as a way of generating tax-free income.

The interest on those loans is taxed as income which feeds back into the model.

If it doesn't happen that often, then it shouldn't be a big deal to change the law.

> Taxes once when you take the loan against it, and taxed again when you realize the profit to pay the loan.

Trivially fixed by simply letting you deduct the taxes paid when you took out the loan against the taxes owed when you actually sell.

While we're at it lets ban stock buybacks since all those are is a tax deferral scheme with utterly no other social purpose. Dividends are the correct way to distribute cash to shareholders. Full stop.

And get rid of stepped up cost basis on death - limit it to the IRS gift limit which is already ridiculously generous. Just to make it politically palatable so there are less sob stories about some "family" farm or company being force-liquidated to pay taxes.

But we don't have to do anything, because any given year we have a cohort of people hitting the time to realize profits.

So while it might be a feel good law, all it's doing is mixing around which cohort is paying up that year.

I agree that the step-up basis is pretty broken though.

A tax deferral that could last millenia.

not really.

I have assets that have a single cost basis of $1

they are now worth $100.

I take a loan secured against 10% of them. I have now taken a tax event against 10% of them.

I now pay taxes on a capital gain of $90 on 10% of them.

I now have an asset split into 2 parts. one with a cost basis of $1 (90% of my assets) and one with a cost basis of $100 (as I paid taxes on a capital gain to $100).

One can perhaps argue that when levaraging unrealized assets for loans, one always uses the lowest cost basis assets for determining taxable event, or perhaps first in first out of taxable events (and therefore paying tax, is an out then an in).

Honestly I wouldn't even care if folks could specify lots...

non-recourse loans don't require payback in case the startup goes under

It doesn't require the debtor to pay back the difference between the collateral liquidation value and the loan value.

I don't think any bank though is giving non-recourse loans for risky or depreciating assets (investors do that). It's usually for things that the bank is confident will be a good investment anyway if the loan goes sour - you default on the loan? Fine. But we keep the land.

For late-stage “startups” (e.g. Series D+ companies that have just not IPOd) they have done this in the past, but that was in the pre-COVID tech mania.

Often they act as middleman, finding someone else that wants exposure to the startup when interest is oversubscribed.

I don’t get how loans can help you “evade” taxes. At some point you have to settle your position. They can help you delay but not avoid the taxes. (Unless I am missing something)

What you’re missing is that when you die, your heirs don’t pay capital gains taxes on the value that appreciated during your lifetime.

You time receiving the money specifically so that you don't hit the next tax bracket, which has a higher tax rate. If you get $1,000,000 in one year and $0 the next, you'd pay more in taxes than two years where you get $500,000 and $500,000 (approximately. don't focus on the exact numbers, but that's the concept).

Why not? I could say the that it is unfair to tax people on income that they haven't spent too. Or property taxes raising for a property they haven't sold. If I wait to pickup my payroll check until after the year rolls over despite earning that money already, should I not pay taxes on it for that previous year?

Because the valuation of equity is notional only. It may not be remotely realizable now or ever. Furthermore, it may not be possible to use it as collateral for a loan for both legal and practical reasons. Some notionally high value assets have no liquid market. It make take a decade to find a real buyer. The large majority of assets held by wealthy people are non-liquid, in the US most studies put it in the 60-70% range.

Your paycheck is denominated in cash money. It can’t go to zero or be non-liquid for years like an investable asset. That’s a rather important distinction.

At least in the case of stock, it’s possible they can’t sell it to pay the tax

That seems like a buyer beware situation. Nobody forced them to invest money in it, and if they lose out in the end that is the risk they take, the same with any other investment. You can't buy a piece of commercial property and not pay any taxes, or start a business and then claw back taxes you already paid because it failed later on down the road.

Would you only apply this to stocks acquired after the new tax law was passed then?

It would probably need a grace period so things don't go crazy, but after that then yes. It would also have the benefit of pumping stocks being lower and more risky, and could help prevent stock bubbles from rising so big and fast.

That is typically the case (depending on the timeline) for all but publicly traded or relatively sought out/well known private firms. Even for many of those, it’s not going to be easy.

You can’t just go out and start selling stock to the public without a huge amount of legal paperwork.

Allow for deferral, but at the risk-free rate. If the asset goes bust, the tax isn’t owed.

Especially if it is illiquid

The taxes would be refundable.

How does that work in practice?

If you're bootstrapped, borrow a bunch of money to pay tax because your company got to $10M val. But then the market shifts and it goes back down to $0 in later years, do you get the money back?

Even if you do, it sounds weird taxing someone for the right to create something, especially when they're still in the middle of creating it.

Yes, you do get the money back, that's the point of the paper.

This is better for many founders that otherwise wouldn't cash out at all. VCs will be forced to cover your unrealized capital gains taxes.

Would they pay interest?

Refundable taxes are often gamed? See Cum-Ex: Dividend Withholding Tax (WHT) Fraud and Missing Trader Intra-Community (MTIC) Fraud.

The conversations around taxation and gov finance in the USA are absolutely delulu. I'm in California. Not including sales and property taxes, high earners are paying over 50% in taxes. Whereas the overall expenditures are unsustainable and in many cases just not working anyway. Notable examples are that we are paying more in Interest than for military at the federal level, and we are burning cash on failed homeless policies without any hope of actual change. Any rational conversation has to cut spending.

> Notable examples are that we are paying more in Interest than for military at the federal level,

It is interesting to me that the party that runs on fiscal responsibility is the one that runs the highest deficits despite having a lower amount of GDP growth.

People aren't versed, and think the problem in their life is that they don't make enough money.

The actual problem (overwhelmingly) is that they spend to much on housing.

If we can just build more housing to bring down prices, 80% of reactionary "just seize their assets in anyway" rhetoric will go away.

Of course, this also means the middle class needs to take a 20%+ hair cut on their net worth. Deeply unpalatable, and doesn't fit the "1% will pay for everything" zeitgeist.

100%, This is the uncomfortable fact of taxes in the US right now. If you are a high earning W2 worker, you are likely paying close to if not above 50% income tax rate. Pretty much on par with all the "high tax" European socialist countries you always hear people complaining about. There is basically no good way to lower this w2 tax burden.

I'm generally a "liberal" and support fair taxation and goverment spending, but the current level, based on the worldwide tax rates I've found, doesn't have much room to grow, especially when it does seem like goverment services are actually supbpar for many, and these taxes don't support some sort of universal health care/cheap university like they do in many European countries. I truly believe that goverment can and should be a force for good in people's lives, but I don't think that means we should give it a blank check. It does feel delulu that so many democrats seems to blindly support raising taxes on the "rich". I do think a wealth tax is very much the wrong approach.

It's pretty frustrating to when folks talk about taxing the rich, since it seems like the policies that get passed often just add even more burden onto the "working" rich vs the capital based rich. Even the long terms capital gains rate is close to 30+% in high tax states + top bracket, but there is way more room for deductions.

I think the line from Abundance is apt- something like, “We’re paying Equinox prices but getting Planet Fitness”

Looks like it's over 50% for regular income, but for long-term capital gains the top rate seems to be about 37%:

  20% federal
  3.8% net investment income tax
  13.3% California

I do what I can to lower my tax bill, but in the end I take a philosophical attitude: if I'm paying more taxes, that's a sign I'm making more money.

From a California perspective, there is no discount for capital gains. It is all taxed as income.

Yep. But they had to include federal to get above 50%, so that's clearly not the calculation they were doing. For federal + California, it does matter.

If I’m paying more taxes, it’s a sign the state is spending beyond its means

I don't see the connection.

And revenue, right?

Waiting for the comments to roll in so I can see if most hackernews commenters view themselves on team Exception or team Rule.

I have worked about half time over three decades on a problem which I recently solved and am developing for a new venture. "Simple" conceptual solution - which took a long trail of reframing to get to. The complete solution is a layered series (actually a cycle) of partial solutions. Each partial solution except one from fields I never expected to be involved. Lots of work left to implement well, but this is the "easy" part.

Getting taxed on any increases in value early would feel very unfair. I have already put in so much value, for nothing in liquid/credible valuation yet, that things would have to go very well to compare equitably with what could sensibly have been expected if I had accrued half-time earnings, continuously saving and investing that income in its entirety, for over three decades.

Further worries: If I don't want to accept any venture capital, and at least for the foreseeable future bootstrap, would I somehow be forced into needing to liquidate ownership based on some accrued wealth rule anyway?

Hopefully not.

But if capital raises are the trigger for accrued wealth taxes, even a small raise after bootstrapped success gets ugly. Imagine raising capital after achieving bootstrapped success, by selling 1%, only to have to pay taxes on 99% of the company's new valuation! That would create a severe disincentive to take any capital ever, after bootstrapped success.

My suggestion: Only tax valuation gains on the sold shares. The realized valuation gain on capital raising shares passes (indirectly) to owners. The realized gains on any owners shares sold to cover those taxes would also pass (directly) to owners, as usual.

That would bring corporate capital raises into exact tax parity with normal owner stock sales.

The only difference is practical: The cash from an indirect sale (capital raise), goes to the owners indirectly (into the company), and is taxed indirectly (pass through). The cash from a direct sale (same sale percentage, but by each owner independently), goes directly to the owners, and taxes are assigned directly.

Either way, taxes are now identical.

(A third case, where all owners sell the same percentage of stock, and agree to all inject the funds into the company, might be a circuitous way to operate, but again, taxes are identical. Taxes on realized gains become sale path and cash purpose neutral.)

It’s a useful lagging indicator. Most here still think they have a shot at being the next unicorn like in the ZIRP era.

I'm on team "I wanna get rich" and also team "I want you to get rich". I'm also on team "I'm a programmer and not a CPA and definitely not your CPA". I pay a money person so I don't have to deal with this stuff because it's not interesting to me, but for those who do find it interesting, game on!

I will say though, that the most important thing someone ever pointed out to me was 100% of $0 is $0. Even just 65% of $really big number is still > $0

Everyone's on team "temporarily embarrassed billionaire founder"

> Using comprehensive new data on U.S. venture capital deals, we find that founder returns remain extremely skewed, with 84% receiving zero exit value while the top 2% capture 80% of total value.

Where is this data from?

An alternative is graduated capital gains rates based on total assets owned (ideally skewed higher, like 10, 50, 100MM, …). Exemptions like QSBS could still be applied. This would allow shareholder control issues to remain unaffected, which wealth taxes never seem to address.

Not sure how to apply it on the corporate side. There are also multi entity workarounds to consider.

Just an idea.

I’ve always been of the opinion tax brackets should be “lifetime earnings” based regardless of income source.

Your first $1M should be taxed differently than your next $10M and so forth.

Quite funny that half of the team who wrote this hail from Switzerland, a country where there are no taxes on realized capital gains, much less unrealized ones.

Switzerland has a wealth tax. That is a tax on unrealized gains fyi.

> Switzerland has a wealth tax.

If the wealth tax rate is close to zero, who the hell cares?

The wealth tax in e.g. Kanton Zürich is 0.025% (not the cheapest Kanton).

If you are able to grow your capital at - say - inflation corrected 4%, which shouldn't be overly hard, and you pay no taxes whatsoever on cap gains while paying 0.025% on the total accumulated wealth.

I'll let you do the math as to how good you have it there.

The highest marginal wealth tax rate in Zurich is 0.47% and 0.9% in Geneva starting at 2-3mn CHF. It's not irrelevant at all

If you now earn 4% on your capital and pay 0.9% wealth taxes that is like a 25% tax rate on your unrealized gains. Inflation is close to zero anyway and interest rates are negative.

Obviously I prefer that system because we can compound essentially tax free to a couple of 100k before having to think about taxes.

No, because they are not exactly correlated with your gains. For what it's worth, you could have an unrealized deficit but still owe taxes. That's why it's a wealth tax and not unrealized gains tax.

Real estate is included in that wealth, of course. And it has a different tax treatment than "usual" stock market gains.

Sure but tax on wealth is a tax on the integral of gains and trying to imagine a tax only on realized wealth seems like it would interest Switzerland but is difficult with real estate and stock markets.

> Sure but tax on wealth is a tax on the integral of gains

If the wealth tax rate is close to zero, who cares?

The wealth tax in e.g. Kanton Zürich is 0.025%

I'd say that is close to nil when compared to the fact that there is no cap gain tax.

The tax rarely exceeds 1% because kantons wouldn't rather derive a larger portion of taxes from wealth tax or because any higher rate still flat across all wealth would cause assets that don't have yearly income to be regularly sold to avoid complexity in holding them?

This theory seems to be BS, If let us say a founder is raising a seed round of 2m at 20m valuation, then according to hypothetical accrual tax rate, they would need to pay a tax of ~ 3-4m.

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