The Carried Interest Tax Debate (continued)

I was reviewing my Lijit stats just now. I wish I could link out to them so you can see them. I had the search term tag cloud up for a while but I felt a little foolish with a tag cloud that started out with pants, widgets suck, and widgets blow, so I took it down. Socialist VCs was also near the top. That one I wear proudly even though it's not true. This post will reinforce the socialist VC tag.

The number one search term that brought people to this blog last week was "carried interest". I haven't written much on the topic but apparently that doesn't matter. The one blog post I did write on the carried interest tax debate is the number five link in Google. And thus the traffic.

I strongly believe that long term capital gains should be taxed differently than short term capital gains. And I also strongly believe that capital gains should be taxed differently than ordinary income. The counter argument is that the economic incentives to take risk with your capital should be enough and you don't need additional tax incentives. I don't buy that. Human nature being what it is, most people are going to want to be conservative with their capital. Taking a risk with your capital, particularly on new business initiatives (whether its a new restaurant in the neighborhood or a cure for cancer), is something we need to encourage. And many of the developed countries in the world agree. In some countries, capital gains are not taxed at all. I don't think we need to take the economic incentives that far.

But, and this is a big but that will annoy most if not all of my colleagues in the VC and private equity businesses, if you are generating those gains with other people's money (OPM), then that is a fee you are being paid and it should be taxed as ordinary income. I really don't see how anyone can argue otherwise with a straight face.

If congress is successful in taxing carried interest as ordinary income, it will massively increase the amount of taxes I pay. So be it. 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.

But the capital that we invest directly in the funds we manage should be treated the same as if we had made the investment directly. When I put the Gotham Gal and my personal capital at risk and keep it as risk for years (sometimes it's longer than ten years), that should be treated very differently than ordinary income. It's not ordinary income. It's a capital gain. And as I stated earlier in this post, let's not throw the baby out with the bathwater in the hunt for a more equitable tax code.

I am not the only VC blogger to come out on the side of change on this topic. Bill Burnham (no relation to my partner Brad) wrote a good post last month. He doesn't go as far as I do on the subject, and his ideas are more evolutionary than revolutionary.

Here are some more links to posts on this topic

PE Hub - Jason Klein Opposed to any changes

Start Making Sense An economic analysis (great name for a blog too)

CarriedInterestTaxation.com Not such a great name for a blog but this one is written by lawyers and is about nothing but this issue. Worth adding to your feed reader if you are tracking the carried interest tax debate.

Comments

[leafar]

You can withdraw words from your lijit search results. See the tuto on lijit's blog
http://www.lijit.com/node/342

I do agree on the carried. VC should put more money into their funds ;-) and risk definitely needs a premium.

[jonathanm]

I would imagine that you are the minority in the private equity / VC world who sees the difference between fee income from managing OPM and direct investments. I completely agree with you that there needs to be both capital and ordinary taxes, and that carried interest falls into the latter category.

The only "sane" argument I've heard for keeping carried interest as capital gains is that the payout is based on performance, and tied to the capital gains. Seems to me like ordinary business income, taxed at the higher rate is also based on performance. I just don't buy it.

I haven't looked at the numbers, but can you imagine how many mid-income people (mllions?) could be taken out of the AMT nightmare if they change the taxation of carried interest on a relatively small group of highly paid individuals?

[Ale]

Couldn't agree more. It shouldn't be easy being named as "socialist" in the US... I would also say that if you invest other people's money but you create value, job and o on then you might get an incentive because this is a still better (socially speaking) job than others.

[Steve Kane]

Bless you, Fred.

This "issue" is really just common sense -- income that is derived without any capital risk, as "carried interest" is, simply can not be capital gains.

But unfortunately we are about to see the painfully massive influence of big money on lawmakers -- and in a particularly ironic form, as the Gulfstream-liberal "fight economic injustice" group twists into a pretzel to defend this gargantuan sop to their own super successful and affluent class.

I mean, how can any self-respecting progressive argue for a repeal of the "Bush Tax Cuts" but argue against this idea, which essentially does the exact same thing, except in a surgical fashion that will, as you Fred artfully point out, increase taxes on the main beneficiaries of the "Bush Tax Cuts" but still not undercut the important, fair tax advantage provided to genuine risk capital which achieves genuine capital gains.

BTW, I also find it amusing that many of the same venture investors who insist that company founders' equity take the form of vesting stock options -- which deprive the entrepreneur of capital gains tax treatment and instead layer in ordinary income treatment -- are now howling in opposition to a tax code change which would put them in the same position.

[rick]

Most people just want to tax VCs because they are rich - but that's not what taxes are for.

Income that is (generally) reinvested should be taxed at a lower rate (or not at all).

The goal should be to raise revenue and promote reinvestment - not just to tax the rich.

[Hank Williams]

I held my breath as I read the body of this post, hoping that you would come down on this side but fearing not.

It is truly unethical to suggest that fee's that VC's earn should be capital gains. It makes no sense. No risk, no capital gain. This is common sense, but people are often unable to separate common sense from their own personal needs.

Reading this blog post made me very happy. Congratulations on truly being a mensch.

Hank

[Bill Burnham]

I think while you and I agree that there's room for some change without the world ending, I also think where we disagree is that I most certainly can see lots of situations where carried interest is in fact a capital gain and can say that with a straight face :-). It's quite possible to invest not just money, but also time ("sweat equity") and intangibles (connections, experience, knowledge, etc.). I believe that our tax code must favor not only those who invest straight cash, but also those who take real risk and invest their time and intellectual/personal capital. It's hard for people to recognize this in the case of a VC or PE professional (who is pulling down millions in management fees), but it's pretty easy to see in the case of a small businessman who is investing their time and expertise (and receiving $0 in management fees) to make a restaurant a success or to renovate an apartment building. Without the ability to allocate profits on the basis of both tangible and intangible contributions, a lot of skill rich/cash poor folks will be at a huge disadvantage while the rich folks that control all the capital will be the only ones to get capital gains treatment. Surely a Socialist VC would not want see a situation in which labor is penalized relative to capital? :-) Put another way, if a VC agreed to work for $0 in management fees but 20% of the profits, if any, why shouldn't they get a capital gain on any profits produced? Is their investment of labor really different from an LP's cash investment? If you answer "yes", you may be sent to a socialist re-education camp. :-)

All the best,

Bill

[Hey]

The problem is that most entrepreneurs use other people's money. They put in sweat equity (divorce equity, lack of sleep equity, gaining 15 lbs equity, etc) but little actual capital as compared with investors.

The difference with PE/VC is that the cash nexus is closer and the investors are more rigourous. We should be encouraging performance related returns on equities, as it increases the apetitie for risk and drives innovation. The tax penalty for performance ties is one of the main causes of an over-reliance on options as compensation (Clinton's "brilliant" ban on deductibility of salary over $1M being the other) to the detriment of aligning investor's interests with management.

Earn outs are VERY popular when acquiring companies (outside of Web 2.0) - what's the conceptual difference between an earn-out in sale agreement and a VC's 2& 20? Where does the managing money nexus disappear - why is a VC an employee while a founder/ceo is a business man who can earn capital gains?

This whole thing is the usual class warfare raised by the ignorant (Rangel), the guilt-ridden (Fred, Bob Rubin), and the malevolent (John Whitehead's anger at the new generation making money being an excellent example). Get the government out of the market, or the market will get out from under the government! London's following the same idiotic path, but Canada isn't - it has always had a very favourable tax regime for capital gains adn is unlikely to join this carry-tax folly!

[Hey]

As to "common sense". Common sense doesn't do economics, opposes foreign trade, can't understand Ricardo, and is occluded by the promise of doing horrible things to the evil "rich". People's behaviors are inherently libertarian, but their tribal instincts tend more towards the communitarian, as long as they are promised of only targeting a minority and not them!

[Gerald Buckley]

Mr. Wilson, I think it's awesome you watch your referrers (appreciating how you come down on the carried interest debate).

[Steve Kane]

@Bill Burnham -- if a fund GP's "sweat equity" somehow qualifies his/her compensation as capital gains, then shouldn't that apply to, well, literally everyone?

by that view, Nicholas Ferguson's "cleaning lady" is contributing time, connections, intangibles, etc., as is every single one of his, my and your and everyone's employees, no? seriously, how are fund GPs special or different in their intagible contributions versus any other person who works for a living?

(for those who dont get the reference to Ferguson: http://business.timesonline.co.uk/tol/business/markets/article1884439.ece)

for me, tax codes should be simple, and simply applied: no capital at risk, no capital gain or loss. certainly capital invested by fund GPs in funds should be viewed as capital at risk, but to view performance fees as such seem like a stretch...

[Bill Burnham]

Steve,

The difference between someone investing "sweat equity" and someone receiving a wage is quite clearly that the person receiving a wage is being paid current period "risk less" cash, while the other person only receives a share of profits should their investment produce a return. There are in fact a lot of people in Silicon Valley including lawyers, recruiters, landlords, etc. who routinely decide to invest their labor in a business and take options as payment for their services instead of cash wages. (I do it myself as an adviser to several start-ups). Those people get capital gains treatment on any profits that those options produce. To use your example, I am sure a cleaning person could strike a similar deal if they were willing to take the risk and if there were profits produced than they would rightly get capital gains treatment because they had in fact made a risk-based investment. As I mentioned in my own post that Fred referred to, I am not in favor of giving capital gains treatment to GPs that are clearly not taking risk, but to those that are I see no reason at all why they should be excluded from getting capital gains treatment. You have to remember that a limited partnership is a business. The GP is hired by the LP to make them money. The LPs hire the GPs because they want access to their intangibles (sweat equity, connections, intellectual capital, etc.) and they give them a disproportionate share of the profits in direct recognition of these intangibles.

[Steve Kane]

@Bill

Granted my cleaning lady example was an odd one, and correct me if I'm wrong, but all sorts of people in all sorts of employments receive compensation of the type you describe (not "risk less cash") yet do not get capital gains treatment.

For example, in your view, wouldn't anyone who works for a company with a "profit sharing plan" be eligible for that compensation to be taxed as capital gains? To my knowledge, the IRS taxes "profit sharing plan" compensation as ordinary income -- yet there is the same element of "risk" as you describe, no? That the employees may get large or small or even no "profit sharing plan" compensation, and that the "intangible efforts" of said employees may directly affect the outcome.

Also, would you allow GPs in funds that lose money to take capital losses for their "sweat equity"? If so, how would you calculate the losses? Under current tax codes, risk capital that is lost may be accounted for as a capital loss -- on a simple dollar for dollar basis -- and such capital losses may be used in certain circumstances reduce tax exposures.

Do you propose that PE/VC "performance fees" also produce capital losses?

And if not, how can a form of compensation potentially produce capital gains if it can not produce capital losses?

Finally, again apologies if I am confused, but I believe stock options received as compensation for employment -- even for employment as a Director or Advisor -- are taxed as wages (ordinary income) not as capital gains.

Any case, thanks for this opportunity to discuss this stuff.

[Bill Burnham]

Hi Steve,

To continue our mini-debate, let me respond to your questions:

1. Profit sharing distributions are indeed typically treated as ordinary income unless they are dividends on an ESOP or preferred stock. The reason why they are ordinary income is that there is no taxable basis for them, i.e. there was no discernible investment made, rather the employees received a reasonably fair cash wage in return for their labor and the profit share is a pure bonus.

2. Should Pe/VC carry product capital losses? On a theoretical basis, the intangible investment made by GPs into an LP should have indeed be able to experience losses, but this would be incredibly hard to enforce consistently so the IRS has split the baby and said you can get the gains, but not the losses (which can be just as valuable). So in some respects the tax code already treats intangible investments unfairly (or fairly depending on your perspective).

3. How can a form of compensation produce capital gains if it can not produce capital losses? Limited partnerships can and do (believe me) produce losses, all the way up to the 100% of the amount invested. If the IRS let GPs establish a basis for their intangible investments (as they do for corporations) than the losses/gains would in fact be proportionally distributed as well. In theory this is exactly what carried interest is trying to accomplish, adjust gains to account for the contribution of intangible assets. The IRS has just decided not give GPs any basis for the intangibles because they don't believe there's any way to reliably establish the value of the intangibles other than what arm's length 3rd parties (such as LPs) are willing to pay for them. In this sense, the intangibles invested in an LP by VCs or any other person are actually already afforded a very negative tax treatment and are truly "at risk" because the GPs can't even write off their losses (unlike the LPs).

4. Aren't stock options ordinary income? This depends on the type of option (NQSO vs. ISO). In the case of an ISOs (which most employees receive), all gains from that are capital gains as long as you hold for a year after exercise (subject to some AMT restrictions). NQSOs require you to pay ordinary income on the difference in strike prices (plus the value received at time of grant in case of an outside service prodvider), but any profits on the underlying shares are taxed at capital gains rates provided you hold them for a year. In both cases, the principle is the same: as long as you are willing to take the risk and let you capital "ride" for at least a year, you get capital gains treatment. There is basically zero theoretical difference between a start-up employee who early exercises a 20%ISO stake and a GP who gets a 20% carry (and currently no tax difference), yet for some reason people want to tax the VC and not the employee. That makes no sense at all.

[Hey]

This just illustrates the problems of bringing in people who aren't familiar with these ideas.

Steve: Profit sharing is more like a dividend payout and for various reasons gets treated as straight income (usually because it is deducted from the company's income statement for tax purposes and so doesn't get the dividend tax credit for corporation tax already paid). Stock options that aren't linked to specific targets are treated as capital gains. The details get very complex very quickly (the whole backdating thing was caused by the complexity of tax treatments that don't make sense at first look but make some sense based on related treatments) but that's the general case. If you have specific targets to get the options, they are treated more like regular income - hence why those types of options aren't given out!

Performance fees DO produce capital losses. Hedge funds have high-water marks - if you go down (or miss your minimum rate of return) you have to get back to that level (or higher) before you get paid again. This leads to instability in the funds: if you have a bad year you won't eat for 3 years and will miss out on 2 years of excellent performance, but shutting the fund and trying again means you're only going to starve for 1-1.5 years (i.e. until you get a new job or can start a new fund).

Steve how do you propose dealing with an undercapitalised entrepreneur who gets equity at $0.01/share and raises money at $5/share or borrows money? Does he "deserve" a capital gain? Does he really have equity in the business?

This is an attack at the basic foundations of the market economy in the US (and UK). If you can only get capital gains treatment in direct proportion to the cash you invest, then there can be NO entrepreneurship or social mobility. You quickly lock in the existing class/caste hierarchy, a feature of honest-to-Lenin Communist states and honest-to-god Feudalism.

Sure now it's just an attack on a relative few "rich" people, but the underlying concepts are foundational to the economy. Fred opposing it is par for the course, as is the approval of many members of the present aristocracy. It cements their position and frees them to pursue noblesse oblige rather than having to keep working to keep up with the Mehtas, Wangs, and Singhs! Our system is based on a slippery slope, so that there is eventually equitable treatment, no matter how outlandish it may seem when that first step is taken.

Any employee is free to take undermarket salary, conditions, and benefits for an equity stake. Startups work like this, as do most of the small businesses in the country. Most small to medium businesses offer equity to long-term employees and key people. Since they're generally set up to earn real money year on year, they get dividends rather than capital gains, but they do have the possibility of a capital gain when they leave of if the firm is acquired. Look at your law firms, accounting firms, and old-school investment banks: you get capital appreciation as well as current profits (taxed as income because the firm was structured to not pay taxes).

HF/PE/VC is designed entirely around capital gains rather than operating income. Statup technology firms and resource firms are also similarly structured/focused, as are many real estate development firms (they sell projects to pension funds and other institutionals investors looking for long-term bond-like investments when construction is completed to free up capital and to help the developer focus on its unique skills).

What's the difference between these types of firms? People close to the cash nexus get more money because they're taking small portions (compared to founders/developers) of a VERY big pie, while most entrepreneurs take a big piece of a small to medium size pie. Every (non-aristocratic) developer in the world got rich off of other people's money, but it doesn't push some people's jealousy buttons like finance does (the Georgists and Maoists get up in arms, but no one worries about them anymore).

[Hey]

Bill Burnham not only types faster but brings in the exact details (unsurprising given our relative levels of experience).

Further on the capital losses idea: these are VERY valuable. One of the biggest assets of many startups/troubled firms are their tax losses. Not being able to write off your losses in opportunity costs, damage of reputtion, etc is one more way how our tax system is tilted against people building businesses. Treating carry as income would be one more strike against those who are building fortunes and reinforces the inherently self-defeating nature of "populist" economics.

Populism is nothing but a tool of the current elite to protect their status from strivers and the nouveau riche while cloaking themselves as the guardians of those they intend to oppress. That's why you have so many billionaire democrats and explains the economic policies of country-club republicans. They make money from the system or can keep out competitors with more regulation. New companies can't bribe legislators or bureaucrats, but the establishment has long connections and always does well in a high-regulation economy - look at the Forbes lists from the 70s, lots of old money, while current ones are all new money, similar concepts can be seen in the Indian economy post independence, where Reliance and Tata were in everything and got their families rich but everyone else stayed porr, and the New India where restrictions are being (very slowly) removed and new fortunes are being made.

[Andy Swan]

Whoever said "The problem is that most entrepreneurs use other people's money." above should be banned from posting about entrepreneurship and venture/angel investing forever.....

or at least until he/she meets a few of us.

[Erik Schwartz]

Andy said:

"Whoever said "The problem is that most entrepreneurs use other people's money." above should be banned from posting about entrepreneurship and venture/angel investing forever.....

or at least until he/she meets a few of us."

I'm with Andy on this one.

Let's see... a year of taking no salary at all (and no outside gigs). X2 because my co-founder did the same thing. We finally get funded, we're both taking less than half what we'd be earning on the open market as salary. Let's say that goes on for 2 years or so...

Plus the actual hard cash investments...

That's easily $600K there...

Now if the series A wants to come in and reimburse us for the last year salary and expenses. AND pay us market rate...

Then we'd be entrepreneurs spending OPM.

[Erik Schwartz]

Oh yeah, and we've been lucky (we're also pretty good, but lucky too), we've actually gotten funded. Most entrepreneurs never do.

Most entrepreneurs who do get funded previously spent long months working on things that never do get funded. Amortize that into the OPM piece...

[Michael]

This is a terrific set of comments. I just want to say that whatever reputation equity Fred may have given up in the Microsoft ad brewhaha was gained back many times over by his position on this issue.

[Hey]

According to these bills and Fred, you should only get capital gains for your actual cash contributions. Since the IRS doesn't let you deduct your sweat equity, it isn't real.

Andy & Eric, I'm on your side. Founders do incredible work and deserve all the success in the world. They create products, jobs, improve our world. What I'm trying to highlight is the extreme similarities between a founder and a GP at a VC fund. You both can't make your ideas work using your own resources, but are contributing invaluable talent, connections, creativity, etc to create something out of nothing at an incredible personal risk. Fred, Pete Peterson, Henry Kravis, et al. do the same thing (ok well the last two are more like Bill Gates), just in a different business.

My apologies if my point didn't come through the first time.

[druce]

You say you strongly believe capital gains should be taxed differently from ordinary income, just wondering why?

If your business is investing or you're an entrepreneur and putting capital at risk is your job, then capital gains are your ordinary income, so why should they get taxed differently from salaried employees?

Doesn't this whole argument show that it's splitting hairs to determine what's gain from investing capital vs. investing labor?

I guess you could make the argument that capital gains are lumpy and in a progressive system they would be taxed unfairly, but you could just set the rate based on the length of the gain.

Certainly the fact that capital gains are not indexed for inflation is basically an expropriation, you own your house for 30 years and it goes up with inflation, and you owe a huge tax with no economic gain.

But if you smooth the lumpiness and take out inflation, I can't see any justification on economic efficiency or fairness for a different rate.

[Just Curious]

Fred if you feel so strongly about this - just curious if you are going to be writing a check to the federal govt for all the carried interest you have already collected over the years . . . seems to me its an easier argument to make when you are already in a position where you don't "need the money" so are happy to pay the extra 20%+ of taxes - wonder if you would have felt the same on the first carry check you received . . .

[Aruni]

Very interesting topic. I agree with Erik and Andy.

It's refreshing to hear a VC/business person say they are OK with higher taxes because IMHO tax money generally helps (jobs, military, programs, roads, schools, support, etc.) more than it hurts.

Since I was born in another country and have relatives around the world, it's amazing to see what the US does with infrastructure compared to other countries who tax their people significantly more.

It's a fine line between taxing too much and not enough but if you are in the position to have to pay a lot of taxes in many cases that is a better position to be in than working for $5 or is it $7.50 an hour. All I know is that I was thrilled back in college when I got a raise to $4.50 an hour working at Mr. Gatti's Pizza!

[druce]

WTF... Blackstone partners get to amortize their gains on the sale as good-will, so whatever taxes they pay now they will get to deduct from future taxes. If I understand this correctly, supposing a future tax rise, they would have paid today's low rate on the gain, and then deducted the gain against a future higher rate.

Debate on rates is a sham, with all the gaming it's just a meaningless statutory rate that only applies to the little people...radical simplification is the only solution.

http://www.nytimes.com/reuters/business/business-blackstone-tax.html

Blackstone’s tax maneuver hinges on its use of good will, an accounting term for the value of the intangible assets, like a well-known brand name, that are built up by a company over time. That value is part of the reason a company is worth more than the sum of its physical parts, like buildings and equipment.

Individuals who create good will cannot deduct it. But when good will is sold the new owners can because its value is assumed to erode. The Blackstone partners sold the good will from their left pocket to their right.

In simplest terms, the Blackstone partners paid a 15 percent capital gains rate on the shares they sold last month in the initial stock offering to outside investors (those shares represented a stake in the Blackstone management company, not its funds).

Blackstone then arranged to get deductions for itself for the $3.7 billion worth of good will at a 35 percent rate. This is a twist on the “buy low, sell high” stock market adage; in this case it would be “tax low, deduct high.”

The deductions must be spread out over 15 years. And the original Blackstone partners are getting just 85 percent of the tax savings, leaving the other 15 percent to outside investors. The deductions on the $3.7 billion to the partners are $1.1 billion over 15 years.