tax.jpgHere’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.