Here’s why we think venture capitalists and other investment professionals should pay income tax rates on “carried” profits, as proposed by legislation in Washington.
The lower capital gains tax rate of 15 percent, which VCs are now paying, is meant to encourage people to take risks, to investment money long-term with a business in hopes of generating superior profits. Encouraging such risks is good for all of us, because it fuels economic expansion and job growth too.
However, the carry doesn’t fall into that category of risk-taking. We’ve come to our conclusion after consulting with Kate Mitchell (see our previous post), a venture capitalist who represents the National Venture Capital Association in Washington hearings, who opposes the tax change. We’ve also talked at length with the tax attorney Mary Kuusisto, of law-firm Proskauer Rose and who is advising the NVCA.
Mitchell, you’ll recall, argued she has invested her own life’s savings into her endeavor as a venture capitalist. She placed her hard-gained cash into her venture fund, alongside the cash invested in by other institutional investors (folks like Credit Suisse, Liberty Mutual, Pantheon Ventures), and argued it was tied up for ten years before she saw any returns. That’s highly risky.
However, the personal money she invests, it turns out, will still get capital gains treatment. The legislation being considering in Washington wouldn’t touch her portion. Rather, it would change the tax treatment on returns from a very different pile of money — that money given to her invest by the other institutional investors (Credit Suisse et al).
Under the contract with these investors, Mitchell and her other general partners at Scale Venture Partners get 20 percent of the profits produced by the firm’s investments. The profits are called “carry.” By giving Mitchell and her other partners at Scale this money to invest, they’re asking her to perform a service. They’re paying her fees, too, in order to render that service — in the millions of dollars. In other words, this part of the bargain is not a risky activity for Mitchell to engage in, even if she argues differently. In our view, then, it is no different from the job performed by the elevator man, a janitor or cab driver, all of whom must pay income tax.
Let’s take an example: Assume, for sake of argument that Mitchell invests $4 million of her own money alongside the money of other investors in a $400 million fund. Assume she is the only general partner. The institutional investors (Credit Suisse, et al.) invest $396 million, and agree she will lay claim to 20 percent of the fund’s profits for managing their money.
A. The good scenario.
Let’s assume things work out great at the firm. The firm makes makes all its money back, and then an additional 50 percent, or $200 million. First, Mitchell gets her own $4 million back, plus $1.6 million as her portion of rightful profits (as an investor, remember, she gets 80 percent of the $2 million profit on her money). Here, capital gains works as it should. It gave her a tax break to encourage her to take risks, and she walks away with $1.6 million more, and that is be taxed at 15 percent, leaving her with $1.36 million after taxes. Moreover, as general partner, she claims 20 percent of the $200 million in profits made on the rest of the $400 million. That’s $40 million before taxes. That’s the carry that Congress is thinking about taxing. If the bill passes, instead of walking away with $34 million, she’ll walk away with only $26.
[Note: She'll have paid income tax on the 2 percent fee she gets in management fees before she realized the carry. However, they're factored out of the profits for determining the carry amount, so this is not an extra tax. The VC lobby does have a quibble, however. The fees are not deductible, resulting in a slightly higher effective tax rate on the carry (yes, this gets complicated). But the legislation won't change any of this, or least that's our understanding of the tax proposal right now, so this is really just a footnote.]
B. The bad scenario
Let’s assume the negative scenario. Let’s argue that the fund gets an early success from one of the companies it invests in, say $100 million in IPO returns a year after investing only $10 million on the company. Mitchell would have to pay a 15 federal tax on her 20 percent portion ($18 million) of the profit of $90 million she locks into. So she pays $2.7 million in federal taxes. However, assume that the firm later losses a total 90 million on its other investments. Mitchell deserves no profits from carry, because the firm hasn’t made any money. So she must give her $18 million back to the firm, setting her back to square one. But she still has paid the $2.7 million, so at the end of it all, she is $2.7 million in the hole. There may be no tax relief on that loss, she says, because losses can only be offset by gains in the future. Mitchell argues this potential loss means she’s taking risk, because of her overall ownership in the firm, justifying she deserves capital gains treatment. However, we disagree with that argument because she didn’t need to lock into that profit early on by selling. That’s a right afforded her by an agreement with her limited partners.
Final note about the WSJ’s math — The WSJ has a piece estimating the total proceeds produced by the tax would be “just” $2 billion, noting it is tiny when compared to the nation’s overall budget. However, we’d argue that is a significant amount, and should be taken seriously given that we’ve got huge budget deficits. Update: A comment below suggests are deficits aren’t so bad. Fair enough. I should add, however, that one group, the Economic Policy Institute, estimates the expected tax proceeds at $6 billion.
7 Comments
-
rj said:
Really, really well put Matt. Nicely done.
I have but one quibble with the article. It seems to have gone mostly without notice, but the economy is so strong (driven in some part by these venture investments) and tax receipts are so plentiful (massive gains, strong profits and plentiful jobs), that we have actually very small budget deficits this year. In fact, if current trends continue, we could find ourselves with a balanced budget in 2008. I kid you not. Watch the monthly numbers released by the Treasury Dept.
So despite your compelling argument on the side of “fairness”, maybe we should be looking at the side of optimal path to economic growth? Maybe we should just stay the heck away from messing with the marvelous wealth making engine that is VC?
The deficit position is well summed up here:
http://www.optimist123.com/optimist/2007/07/deficit-watch-j.html -
eli said:
If PE investors were not required to invest their carried interest into the fund, but rather chose to invest, would you tax the 20% of profits at income tax rate and then the gains on the reinvested capital at LT capital gains?
-
uf911 said:
I’m assuming that this legislation proposes that only distributions to investors are taxable events, not distributions to the fund that aren’t immediately distributed to investors. If this assumption is true, even in the ‘bad scenario’ Mitchell would likely come out ahead, not $2.7M in the hole.
If her share of the $100M IPO was distributed to her, and she paid $2.7M in taxes on her $18M take, she would have the use of $15.3M for the remaining term of the VC fund. Because most funds have 5,7, or 10 year terms, she would have the use of $15.3M for between 4-9 years. Assuming a savvy investor like a VC GP could get a 10% return on this capital, she would still have a $6M after-tax gain. Even after returning the $18M to the under-performing fund she’d be left with $3.33M. Since the $2.7M tax had already been paid, this $3.33M would be hers to keep.
Not too shabby for an under-performing fund, even before taking into account the management fees.
-
One Way Stox said:
Long-term cap gains are long-term cap gains are long-term cap gains are lobg-term cap gains!
STOP BEING SUCH A LEFTY, MATT!!!
-
krish said:
Why all this fuss over tax treatment in an industry which has a high probability of losses / write downs?
It’s becoming increasingly difficult for VCs to make money now since there are too many funds chasing too few ideas. Investment horizons are getting longer and >5x returns are getting fewer. In the end, after setting off losses most VCs are getting little by way of `carried’ interest. It’s just the management fees/salary they are living on and that’s subjected to Income tax. The occasional carry that they may get, while getting distributed will qualify as *capital gains* only to the extent that relates to their personal savings invested in the fund. Not that portion of the gain that accrues on investments made by other limited partners - which when distributed to VCs as carried interest, IMO, should be treated as `income’ and not as capital gain.
If not, it is abuse of the legislative intention behind the tax statute and shapes up as “Tax Avoidance” (a quirky device used to avoid taxes by twisted interpretation of the law, less culpable than “Evasion” but still unethical if not illegal)and not as legitimate as “Tax Planning” - which is full use of the framework provided by the statute to save taxes.
-
Tax Shelter Hotline said:
well, i’m a little biased but i’m all for paying as little tax as legally possible—pk
-
Scott said:
Hey, Matt. Your article is well written and a reasonable summary of how the economics could work in the venture capital industry. I’m jumping in late, so I apologize if this has been covered before, but I wonder if you are really consistent in your view that if someone else is getting paid to manage an investment, there should be no long-term capital gains treatment?
Specifically, I wonder whether an entrepreneur should receive capital gains treatment in the following scenario:
- Seed investors (VCs or angels) invest $500k in your idea, allowing you to get started. You take no salary for the first 9 months, spending the money on R&D. Essentially, you are getting paid to manage their investment, because in many cases that founder’s stock you hold wouldn’t even have been issued without the startup capital that paid the lawyers to file your incorporation.
- You introduce the product, and it doesn’t quite work. You run out of money a few times along the way, but your investors keep funding you, and the combination of your enthusiasm, large market potential, and progress on the science allow you to keep going. You have started taking a small salary, and you pay your employees below market wages.
- You get some good traction in the marketplace and over time raise a modest total of $20M on your way to profitability. Every time you raise a larger round, your salary gets more in line with market rates, and as the company develops a strong position in the marketplace, employee salaries become very competitive. Your company is known as a great place to work, and as you inch towards an IPO, there is in fact very little risk in working at your company compared to the startup phase.
- As you prepare for an IPO, you get bought by Google for $500M (after M&A fees, etc.) instead. You still own 8% of the company and you get long-term capital gains treatment on $40M.
I’m not sure how the scenario above is substantially different from your Credit Suisse example. You can argue over the definition of whether the entrepreneur is managing someone else’s money, but that’s purely semantics. Someone else has put up the money (all of the money, in fact). It was risky, because things could have gone well or poorly. Should it matter who put up the money? If that’s the key issue, then the legislature should wipe away capital gains treatment for all entrepreneurs, too, except to the extent that they self-fund. It seems that the perverse crux of most arguments against VCs receiving long-term capital gains treatment is that only those who put up the money should receive a benefit. Ironically, this would shift the favor heavily towards only those who already have money. You can decide for yourself whether you are being philosophically consistent to believe that entrepreneurs and not VCs should receive preference when someone else puts up the money, but it is beyond debate that it would be poor policy to remove incentive for entrepreneurs to take risk. What entrepreneurs do is very difficult, and it should be nurtured and supported.
Personally, I think the real issue is the definition of long-term. When a VC makes a bundle in 13 months, maybe it isn’t what the long-term capital gains law really contemplates. Perhaps we should make the criterion 2 years, or 3 years, or even 5 years. Some European countries even have a graduated step down on their capital gains tax that goes to zero over a long enough period! This sounds complicated to me, but maybe a 2-3 year definition of “long-term” would be a more appropriate barometer of how the industry really works.
Ultimately, this law says that if you hold a share of stock over a certain period of time, you can receive long-term capital gains. If you start changing what it means to “hold a share of stock” saying that some stocks qualify and some don’t arbitrarily, you are headed down a slippery slope of shoddy intellect. We are already doing enough to diminish our country’s ability to compete in the global marketplace, let’s not compound the problem by reducing the incentives for those who are taking risks to produce jobs and new products and wealth for our economy.
9 Trackbacks
9:25 am
VentureBeat » VC tax dies in Senate, but lives in UK said:
[...] capitalists and private equity mangers deserve to be paying the higher rates, because they’re not taking any risks with the investments they’re making. The tax [...]
12:00 am
VentureBeat » VC lobby gets entrepreneurs to fight VC tax said:
[...] argued several times that raising tax on the carried interest of venture capital profits is the fair thing to do — [...]
2:09 am
VentureBeat » Mitt Romney flubs understanding of the VC tax said:
[...] money, i.e, the money they get from the big institutions that provide the money to their firms. As we explained in our earlier story about the VC tax issue, the profits VCs make from investing their own capital remains at the low capital gains rate of 15 [...]
5:16 am
El Mike’s Internet News Blog » Blog Archive » House Moves Forward Plans To Change How VCs Are Taxed said:
[...] limit the interest in investing institutional money. However, others, such as VentureBeat, make a compelling case that while profits on your own invested money should (and would, under the plan) remain as a [...]
11:06 am
House Moves Forward Plans To Change How VCs Are Taxed | www.theirway.net said:
[...] limit the interest in investing institutional money. However, others, such as VentureBeat, make a compelling case that while profits on your own invested money should (and would, under the plan) remain as a [...]
11:19 pm
VentureBeat » Roundup: Warner CEO changes online music stance, engineers become scarcer, and more said:
[...] “nothing to lose” crowd. For more on why VentureBeat thinks the tax should pass, see this post. Joost gets creative with the ads – A new “advertising widget” called Coke [...]
3:35 pm
VentureBeat » Roundup: VC tax fails, Feedster folds, and more said:
[...] Senate blocks carried interest tax, closes loophole — The National Venture Capital Asoociation expressed its gratitude to the US Senate for dropping a provision to change carried interest tax rates, again. This isn’t any real surprise — we reported in October that the bill would likely fail in Senate, as it has before. Senator Charles Rangel, the Democratic chairman of the Ways and Means Committee, promised to “continue to pursue this issue.” For more on why it’s an issue, check out our past post arguing for the tax. [...]
9:42 am
VentureBeat » Carlyle’s Rubenstein “hooted off stage” at VC-buyout conference said:
[...] $300 stone crabs, raising questions whether the buyout industry was paying its fair share of taxes (we’ve covered this in detail). See poster at left, which describes some of the [...]
3:22 am
Investment Plan For Investing In Stocks said:
Investment Plan For Investing In Stocks…
Investing In Penny Stocks Online Brokers…