The Carried Interest Debate – Down to the Wire

Unless you have been living under a rock, you’ve no doubt read about the debate in Congress going on regarding carried interests for venture capitalists.  Many in Congress, in order to continue to fund their agenda, are looking to change the tax classification of VC profits from capital gains to ordinary income.

It looks like the next 48 hours will determine how this debate works out.  The finance folks on the Hill are in full swing deciding on a number of issues, including the good news today about leaving angel Investors alone and allowing at least that part of the startup ecosystem to remain unscathed. 

As for the carried interests issue, it’s been overly-politicized in a myriad of ways including those who like to frame this as class warfare, those who see this issue as just a bunch of winey VCs who don’t want their taxes increased or those who claim that VCs make money off of services and should be taxed accordingly.

I don’t think any of these are accurate.  What this is really about is the future health of the innovation economy in the United States.  It’s really that simple.

Now don’t get me wrong.  I understand the political rhetoric.  Every time a new tax is proposed, some group of politicians rise up claim the sky is falling and that the new tax will “kill” an industry.  The fact that it usually doesn’t means that when there are real concerns, they fall upon deaf and / or suspicious ears.

I’m not one of those folks.  I don’t like taxes (like most folks), but understand that in many new tax cases the markets adapt and life goes on.  I honestly feel, however, that this is not one of those cases. 

Whatever you believe about VCs, their wealth, they way they earn their income, etc., one thing that is apparent is that VCs partner with great entrepreneurs to create jobs.  And we create a lot of them.  In fact, we risk our personal wealth and reputations to invest money in highly risky startups that take 5 to 10 years to mature in these efforts.  

Most of our investments do not work out as we plan.  The ones that do, create sustainable, long-lasting jobs that benefit the job market today and for future generations. 

And for this, Congress is thinking of effectively tripling the tax rate on our risky efforts.  This at a time where job creation is the single most important issue our country faces.  This at a time when countries like China and Russia are considering EXEMPTING VCs from taxes that invest in startups.  This is simply stunning to me.

We’ve already seen a lot of investment capital (from both VCs funding startups and those that invest in VCs) go overseas to places like India and China.  Anyone who is active in our ecosystem knows that money available to U.S.-based startups is less than it has been in 15-20 years.  I guess that i could argue that 2009 might have been a bit worse, but go ask most entrepreneurs or VCs what it is like to raise money these days and they won’t wax poetically.

And the Congress is saying: “hey, we don’t care.  Take more of your money overseas.  In fact, let’s move all the VC activity offshore.”  What’s left of our long-term economic viability if we give other countries the ability to compete better than we can?

Nice.  Really nice. 

Another argument that I love is that “VCs haven’t returned profits in the last decade to their investors, therefore they shouldn’t get incentive-based tax treatment.”  This makes no sense on a number of levels.

1. It’s arguably true if you look at the entire industry, but says nothing about many funds who are successful making their investors money.  We cannot assume the successful VCs will continue to want to work hard  if their taxes are tripled; and

2. And, if true, this just proves my point about how risky all of this activity is, further supporting the point that incentives need to exist.

And remember, VCs do pay normal income taxes on management fees (salary) that they receive.  And many VCs return all the management fees to their investors before they take profits, so effectively they are paying normal income tax rates on money loaned to them. 

But what worries me the most is the slippery slope that we are going down.  Even if you believe that VC profits should be taxed as services/income, then how on earth do you distinguish this from the cheap equity that founders allocate to themselves when starting a company?  Isn’t all of their success based on the labor and services as well?  While VCs may be using other people’s money to invest, so are entrepreneurs.

So how do you distinguish?  Answer:  you can’t.  Entrepreneurs, you are next. 

Bottom line, the Congress is going down an irreversible path that threatens to undermine the innovation economy in this country.  I hope that logic, instead of politics, prevail.  We’ll know shortly the answer.

  • According to your post on, October 22, 2009:

    "As the Obama administration starts to talk about propping up small businesses with the next phase of the bailout, I’ve begun hearing noise from some venture capitalists and angel investors that the government should provide financial support to startups, early-stage venture capitalists and angel investors.

    All I can say to this is “vomit.”"

    Why exactly is your tax subsidy different?

    • Totally different.  I vomit from the idea that VCs and their companies are getting taxpayer dollars to bail them out / prop them up.  There have been a lot of these and I don’t support any of them.  In fact, I know of three alone that have taken over $1 billion in taxpayer dollars and there contract / return mechanism for the taxpayers stinks (like GM).

      This is a direct handout.  Carried interests are completely different.  There is an almost perfect  substitute good in China / India / other countries and the US Congress is going to ferret investment out of this country to another one.

      And one more fun fact.  It is estimated that the VC portion of this will be worth somewhere between 1 and 1.5 billion dollars of tax dollars.  The three bailouts that I know of totaled the same amount. 

      This is about saving an industry and ecosystem, not about a bailout to specific companies which I strongly don’t support.

      • Vic

        Paying tax at a lower rate than other people is a tax expenditure. I understand your argument that it is a worthwhile tax expenditure, but it's economically equivalent to a higher tax rate coupled with a subsidy.

        The auto industry bailouts saved a lot of jobs, but neither of us liked that move, right? The VC industry helps entrepreneurs create jobs. To get a carve out from carried interest reform, you'll have to show me that (1) a low tax rate on VCs is the best policy instrument for subsidizing entrepreneurship and (2) it's possible to carve out VC from PE, oil and gas, and commercial real estate. I'm willing to be convinced, and as you probably know I originally testified in favor of a VC/small fund exemption.

        We usually assume that labor market activities should be taxed at the same rate unless there is some market failure that requires a lower tax rate. What's the market failure here — if, say, 10% of the VCs in the US move to China/India — I think the real number is more likely 1% — then why won't others fill their shoes? There's a limited amount of LP capital, and a limited amount of entrepreneurs, but quite a lot of people that want to be VCs. I guess the argument is that the replacement VCs — folks who are angels and PE investors now — would be poor VC investors?

        • Yeah, the VC-wanna-be backlog is long, but look at the overall performance of the industry.  It’s tough being a successful VC.  We aren’t fungible and it’s not really a “learned” skill.  Part nature / nuture.

          And also, many of us had nice paying professional jobs before VC and made career changes to go into VC, which has a lot more risk of salary, but larger upside.  By killing the upside, there is a different calculus.  I’d would have made more as a lawyer than a VC – which clearly is the case if the tax is passed.  At this point, I can’t go back to law, but what about the next “Jason?”  (insert snide comment that VC doesn’t need 1 Jason, much less the next one).  J

          Carve outs are easy.  You can define a number of ways from size of investment, use of leverage, average holding periods, qualified small business status, etc.

  • Bill Burnham

    Amen. Although given the way the wind is blowing I'd be surprised if it doesn't happen. Given that, what do you think of my solution in the event they ban "carried interest" (works for VC/PE, not necessarily hedge 🙁 ):

    Step 1: Create special purpose LLC
    Step 2: LP contributes $X
    Step 3: GP contributes $Y
    Step 4: GP contributes non-exclusive trademark license, promotional agreement, strategic partnership agreement, and other such intangible assets as it deems appropriate in return for 20% of equity in SPE
    Step 5: SPE invests $X+$Y in portfolio company and signs agreement to license all the intangibles

    Carry is just compensation for the contribution of intangible assets (reputation, contacts, investment management acumen, etc.). My solution requires more paperwork, but it would be pretty hard to challenge as there a huge number of deals structures like this in areas such as medicine and entertainment already. My guess is something like this is what firms will come up with.

    • Yep, I think this works.  Of course the clawback issues make my head hurt.  But there have been some smart tax folks who came up with similar ideas a bit ago, but none worded so eloquently as this. 

  • SM2

    Carried interest is a very important part of the incentive structure for investment teams. While I think both sides have fair points, I am not sure I understand your argument. The capital available to VCs should not change as LP tax treatment will remain the same so the capital at risk, LP money, will still get favorable treatment. I do not see why this would translate into less net jobs (which is what I think is your point ).

    Attempt at a solution. LPs can lend the 20% GP to invest day one. Now as an investor (and now with real money at risk) the tax treatment will be favorable.

    • The point is, if VCs can invest in other countries that offer zero tax, they will over a country that proposes 50% taxes, which is what happens with change from capital gains to ordinary income. 

      • SM2

        Got it, that is a fair point and one I have not heard often. It would be interesting to see how this has worked in the past, cap gains rates have varied in the US as well as across the world.

        • I saw a presentation once (yes, total heresy at this point) that I wished I kept the materials.  It had a graph of capital gain rates versus economic growth of countries.  Now, there are lies, damn lies and statistics (tongue in cheek), but the graph was pretty compelling that there was as direct correlation between having low/reasonable capital gain rates and growth.

          I know the research is out there.  I just haven’t been able to find it.

      • gma

        global taxation doesn't work that way. a us vc investor will pay the same tax regardless of where he invests

        • Nope.  They’ll set up entities in China and India to directly invest.  It’s easy to do and many are already doing it to escape US tax burden.  This will just make it worse. 

  • Wait, while VCs sometimes contribute their own capital to a fund, for the most part they are risking other people's money. When an entire fund goes sideways, the VC does not lose net worth, just potential earning, right?

    Also, I sincerely doubt that this is going to somehow shrink VC. Seriously? What are the alternatives? Suddenly VC's en-mass are going to quit and go into other industries because a billion dollar exit is going to be taxed harder? Most of the quality VCs are in it because they are passionate about what they do, love working with companies and creating value. Will that suddenly change because they're going to make 65mm instead of 85mm on a huge outcome? Suddenly they're going to become Hollywood directors cause there's no money in VC anymore? This won't change LP investments and outcomes right? Or suddenly these VC professionals are going to move to China to rebuild a network there? And the bottom line is this doesn't affect the exit environment, so if there are still big exits available, seems like there will still be ample appetite to fund startups from LPs.

    I'm 100% against raising the bar on accredited investors, I see how that will have an immediate and chilling effect on the overall VC economy. But the tax on carry seems to make VCs a little less super rich, which does't seem to draw a ton of sympathy and I just don't see how that will realistically affect the ecosystem. I could be wrong, and I'm 100% against anything that could shrink the investment environment, but I just don't see it right now.

    • Mike, for what it may be worth, I heard Mark Heesen of the NVCA speak at an Angel Capital Association in San Francisco this month, and he said that if the rules change on the taxation of carried interest, "you will see many venture capitalists turn into angels."

      • Steven Kane

        meaning, they will start investing their own capital, instead of LPs money? and collect zero management fees?

        • Yes, exactly. Take their own capital and leave their firms and invest their own money.

          • Steven Kane

            Respectfully, I think that will be the day when hell freezes over.

            😉

    • Actually VCs put their own money into the fund as well.  It ranges from 1-5% normally, but it’s real money and a real amount of wealth.  Also, I do think that VCs will go do other things.  Certainly there will be VCs who stay as VCs but go to China and India.  This has happened a ton already. 

      • Steven Kane

        I, for one, would really like everyone who wants to leave this country because of tax rates just hurry up and go already.

        For this democracy to work, we have to accept that the laws and yes, tax rates, are designed and continuously redesigned to do the most good (not all good) and the least harm (not no harm.)

        I hate the threat, er, I mean, argument, that people will emigrate in a huff unless the laws and tax rates are made to work just their way. Good riddance to people like that, no?

        We have a huge supply of super smart folks, and enormously energetic talented young people and immigrants dying for the opportunities that our system creates and enables. Let the old entrenched establishment flee to Bermuda or the Cayman islands or wherever. We have ample capital and talent to step into the breach…

  • Why do say "Entrepreneurs, you are next"?

    To my knowledge, there is no movement or even discussion to change the tax status of founder or direct investor equity. Are you saying you know of such a movement? Founder or entrepreneur equity is created by company formation or direct acquisition using capital. While capital gains tax rates do go up and down (they are going up soon) i am aware of zero efforts to remove the designation entirely.

    "Carried interest" is a fee paid to fund managers when funds perform above a certain level of return. Recipients of "carried interest" have zero capital at risk — if the fund does not perform at that level they may receive zero carried interest but they do not have any capital losses. So the tax status argument is that capital gains treatment should only apply to gains or incomes derived where there is potential capital loss. Kind of a common sense argument, no?

    Again, if VC GPs/partners invest capital in their funds or deals, the gains or losses derived from such are treated as capital gains. Only the success fees — the carried interest — is at risk of losing its status as capital gains and instead being treated as ordinary income.

    Why should this type of fee get special designation as capital gains? Investment management success fees are a form of ordinary income — their designation as capital gains is a recent, and unique phenomenon. This porposed change is a reversion to the norm, not a special case, I think…

    • You are correct – I know of no current movement to change entrepreneur tax status.  But once we go down this road, what’s to stop the Congress from doing this?  It’s the exact same argument.  You can also apply the same analysis to LPs and at that point the entire notion of capital gains is gone. 

      • Steven Kane

        That's a specious argument at best.

        "Once we go down this road"? You mean, "once we revert back to the norm.

        And "What's to stop the Congress from doing" anything? That kind of logic (or lack thereof) sounds not like a rational investor and businessperson, and more like a survivalist in his bunker in the woods, or a "birther" alleging that Obama is a foreign alien, or a "truther" saying the government was behind 9/11.

        We all have to more fairly and rationally share the tax burden. A special exception to the extremely common sense definition of what constitutes "capital gain" (e.g. where the recipient had their own capital at risk of loss) that benefits only a class of individual who by any standard is already extremely well compensated already (regardless of whether or not they collect carried interest) was always a marie antionette-ish idea, and today, in the midst of a deep and scary and possibly longterm crisis, it is outrageous.

        (and even dangerous. the majority of people in this country are already horrified and wounded and bitterly upset at the unfairness of the economics of the USA. to shove explicit handouts to the rich in the faces could be like throwing gas on a fire…)

    • +1. This makes me think you don't really know how we are taxed. As an LLC member I pay a shitload more taxes than you. Ever heard of the self-employment tax? Principals have to pay it. Investors don't.

      • Actually, you are the one who doesn’t understand tax.  Carried interests are with respect to when you sell a business or have a realization event for equity one holds.  This isn’t about money that comes out of the business / salary.  That is taxed as normal income.  I’m a LLC member too for that part of the business.  If you were to sell your business, you’d get capital gains treatment on your equity. 

  • "…If you are generating those gains with other people's money, 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."

    –Fred Wilson http://www.avc.com/a_vc/2007/06/the-carried-int.h

    • I don’t agree with this.  Love Fred, but we don’t agree on this.  And per my blog, this is no different than how entrepreneurs or LPs are taxed. 

      • Steven Kane

        as per your blog, it is 100% different. LPs have capital at risk. as fred points out — their own capital. GPs (VCs) carried interest is gnerated based NOT on investing their own capital, but on someone else's capital. coudn't be more different

        entrepreneurs create value by creating companies. the compny stock is orth zero until or unless they make it worth something, by investing their own dollars and sweat etc. VCs do not do this. period. they invest other people's money in securities, usually startups. VCs are agents, not principals, brokering investments and gtting paid management fees and carried interest fees.

        argue for your special exemption from the tax law if you like. thats' entirely your right of course. but it is an exemption. VCs are not LPs and VCs are not entrepreneurs. that is just, well, unsupportable.

        • I think you are missing the point.  Here’s a better attempt at the argument.

          Yes, VCs aren’t Entrepreneurs and aren’t LPs.  That’s for sure.  In fact, I like most Entrepreneurs and LPs better than VCs.

          The argument that you are making is that VCs do two things that should classify carry as ordinary income:

          1. Don’t use their own money to acquire their securities / equity
          2. Work / services for their profits.

          In no way do I think VCs add as much value as entrepreneurs.  That we agree on, but the argument is that I don’t see the real difference from a tax standpoint  / IRS view.  You are arguing policy.  That’s fine, but I’m not.  I’m arguing the slippery slope of government taxation.

          You say that entrepreneurs create value by sweat.  Totally agree.  But sweat = ordinary income in the eyes of the tax folks.  There stock entrepreneurs (founders) hold is “free” for the most part.

          I don’t want entrepreneurs to pay ordinary income taxes.  That would be the death of the industry.  I think once you make this argument for carried interests it’s a small jump to say that founders, who get cheap / free stock are building value through efforts and work and this should be income.  And that scares me a lot. 

          • Steven Kane

            Respectfully, you are missing the point, I think

            As I stated again and again in my other comments — capital gains tax treatment should only apply to income derived from a situation where capital is at risk. if Vcs have capital in their funds, they get capital gains treatment on gains, if any.

            Carried interest is a fee for service. Period. If VCs do not receive carried interest from a fund, they had and have zero potential for capital loss — they had no capital at stake.

            Therefore, carried interest should be taxed like any other fee for service… as ordinary income.

          • And how is this different than an entrepreneur who raises VC money and has none of their money at risk?

            Totally get the “life risk” – it the company fails, it sucks, their reputations are lessened and they’ve given up other opportunities, but same thing with a failed VC fund, too. 

  • Denise

    How do you reconcile the fact that employees stock options are taxed as ordinary income (leaving aside the small number of ISOs) – there are a lot of similarities in terms of risk and lack of direct capital, building of the business, etc – between a VC's carried interest and an employee stock option.

    • Employees can purchase / exercise their shares at any time and hold for 12 months and receive capital gains treatment.  The lack of ISOs trouble me as well.  Was a much better system in the “old days.”

      To be clear – I’m all for all employees getting capital gains and wish there were next exercise / tacking period opportunities like there are in warrant issuances. 

  • Jack

    Jason, you're either greedy or delusional. I know some VCs love to think of themselves as risk-taking entrepreneurs. VC's are agents. They take LP money and invest it for them. VCs should be taxed on their income from this activity just like any other broker or agent.

    You've enjoyed a free ride for many years. It's time to stop stealing from the taxpayers and pay what you rightly owe. And please, stop trying to scare your readers into thinking the government is going to confuse real entrepreneurs with agents. It is insulting to our intelligence.

    • I probably have no chance of arguing that I’m not greedy, as I certainly have a financial stake here, so while I don’t think that I am, this isn’t an argument that we can debate productively.

      As for delusional, I assure you that I’m not, however.  I don’t know what the percentage is, but I don’t think most VCs are agents.  Your experience may be different, but all the ones that we associate ourselves with work very hard to add real value to our companies.  In fact, I’d be shocked if our company executives didn’t agree. 

      We aren’t brokers / agents.  We certainly aren’t as active or value add to a company’s success as entrepreneurs, but we try to be helpful and do provide cash for them to prove their worth

      As for scare tactics, I don’t think any of us are qualified to guess what exactly the government will do next.  If you told me three years ago that the government would own 60+% of GM, have bailed out the financial industry, provided below-market term loans to certain startups and created programs like cash for clunkers and the like, I’d told you that it was impossible.  They’ve spend an incredible amount of money and even if they do change these taxes, they are still going to need a lot more.  They are already proposing to double the capital gains rate?  Why stop there?  There is no bright line between the taxation of these different constituencies. 

      • Jack

        Stock brokers help their clients put together financial plans, and then assemble investment portfolios to meet those goals. Real estate agents help their clients either sell or shop for homes, providing market advice, analysis, and marketing support. They both "add value" to the client transaction. How are VCs any different?

        Also – I'm not sure what is so offensive about using words like "greedy" and "delusional", when either or both may apply. As a taxpayer and entrepreneur, I am offended by VCs asking for special tax consideration for what is clearly ordinary income.

    • Jacob Plummer

      How is it intuitive that venture capitalists are "stealing from taxpayers" unless ordinary income rates are increased…?
      If Limited Partners felt that venture capitalists were being "overpaid" (which seems to be the rationale of the government) then why were they not asking to (or not able to) negotiate a 90-10 split, rather than the 80-20 split?
      I don't know who here is greedy or delusional, but I think that usage of those inflammatory terms are generally the province of people who are not persuaded by the merit of their own arguments.

  • Jason –
    You are right on the money when it comes to why this discussion is critical to the innovation cycle upon which the re-birth of the American economy is dependent. The only way we avoid following Greece (and we are right behind them) is to create new industries with their high paying and highly differentiated jobs in the America. This is the key to not only our standard of living but also tackling the sticky issues related to our massive national debt. These jobs are the output of the venture ecosystem. (to be contd. post too long)

  • (contd from prior post) Our economic policies (including tax) should be focused on how we encourage and stimulate as much innovation as possible in America. Venture Capital is "a" key element of this process… and tax rates do have a material impact on the risk/reward relationships associated with start-up based innovation. Plain and simple.
    (to be contd)

  • (contd) As for those who couch their arguments against long term capital gains treatment for Carried Interest on "fairness" – let me point out that our tax code is and has almost always been a tool to achieve social and economic objectives. I would put high paying job growth at the top of the list of priorities in both of these cases. Lest some think, venture capitalists are being singled out for special treatment… "Why is interest on home loans deductible when rent is not?". "Why were there tax credits for new home purchases over the past year?"

  • (contd) We have a long history of tax breaks for investment in research and development or for purchases of capital equipment?" "What about donations to non-profit organizations improving the quality of life in America?". The tax code favors these activities because they are deemed to be beneficial to our society and something to be encouraged. I would make the same argument for job creation in America, especially the types of higher paying jobs that tend to sprout from the venture ecosystem. Don't believe me, ask someone who is unemployed or marginally employed. (contd)

  • (contd) As for the suggestion that it is “OK” for venture capitalists to invest their capital and ability off-shore, this is already happening. Frankly, in many cases, the capital is following the foreign-born entrepreneurial talent that once dreamed of building their lives in America that are returning to the lands of their birth – including India and China. And remember, the combination of capital and talent that are fueling the explosive job growth in these emerging economic powerhouses – are creating jobs that don’t employ Americans or pay US taxes.
    The matters at hand are economic and vital to the growth and viability of the American economy. Given the choice between job opportunities tied to venture-based innovation or a job working for General Motors or the Federal Government, I know how I would vote. (END)

  • Jason, this is a wonderfully written post. I also think there is a lot of room for intelligent, reasonable people to disagree about the esoterics of tax code treatment, etc, and for the most part the debates I have been part of at NVCA, on Capitol Hill, and in social media have reflected that responsible discourse. It’s unfortunate that some people, as always, have resorted to name-calling but that will always be the case.

    On the merits of the issue, I think what gets lost in the pedagogy of the debate is that tax policy is not a philosophy or an ideology – it is simply a technology. Tax policy is a tool used by the government to incentivize certain types of activities and discourage others. That is why taxes on tobacco are so high, why mortgage interest is deductible, why farmers in the Midwest are subisidized to grow corn (or often, to NOT grow corn in order to restrict supply and keep prices high) and why lots of techies get a tax break on their Priuses. It’s perfectly reasonable – and appropriate – for the government to make decisions about incentivizing certain types of activities and disincentivizing others.

    (Reasonable and smart people can and have argued that such a government approach is NOT appropriate and argue that the government should not favor any activities over any others. While I don’t share their view, I recognize its intellectual validity. That argument, however, is much larger than the scope of this issue. As long as we have government tax policy that does incentivize some activities over others, I believe it is reasonable to discuss whether or not venture capital investments in small businesses are a good incentive or not).

    So, the question for me is simply, should the government craft a tax policy that incentivizes the type of investing that venture capitalists do, or not? I am a strong believer that it should, with the caveat that for me, it is the *type* of investment and not the form or structure of the investor that matters. I believe the government should incentivize non-leveraged, long-term, high-risk equity ownership investments in companies founded by promising entrepreneurs who don’t personally have the financial wealth to fund the company themselves.

    Angels do this kind of investing, and deserve to be incentivized by government tax code. VC’s do this kind of investing, and deserve to be incentivized by government tax code. Anyone else (banks, companies, overseas investors, etc) ought to be similarly incentivized. Not because it is the “right” or the “fair” thing to do, but because it is good government policy, because it creates economic growth and new jobs at a higher rate than any other form of incentive. Certainly more than growing corn for ethanol, or NOT growing corn in order to keep grain prices high.

    Next, the question is, should government tax policy incentivize the creation of entrepreneurial value in start-up companies if the means of such creation is not purely via capital? Again, this is a reasonable debate to have. Lots of people have strong opinions about whether, in their personal view, venture capital investors “deserve” to be incentivized to add their networks and expertise and sweat equity alongside the entrepreneurs. If you are a person who holds the belief that a venture capitalist – by definition – does NOT add substantial value in the entrepreneurial wealth creation process, then it certainly is logical to argue that VCs should not be incentivized.

    That said, however, the most important element of Jason’s post, in my view, is the slippery slope. If you are going to argue not from an incentivize/tax policy standpoint, but from a philosophical or structural “fairness” standpoint that ONLY cash investments can receive capital gains treatment, then you are actually arguing against a much larger portion of the economy than just VCs and carried interest. The majority of energy production, the majority of real estate development, a large number of small and family owned businesses, and nearly all startup entrepreneurial companies rely on the premise that some people contribute cash, others contribute other intangible assets ranging from IP to sweat equity, and in the end, they all benefit from capital gains tax treatment on the growth of a capital asset that results.

    From a philosophical or ideological standpoint, if you want to argue that ONLY capital should be narrowly eligible for capital gains treatment, then you are inadvertently going to to eliminate the ability for company founders to be taxed at capital gains rates for the value they grow in their businesses. Along the way you’ll penalize everyone who started a restaurant with seed money from their uncle, everyone building apartments in their neighborhood using capital from third-party investors, everyone wildcatting for energy resources that the world desperately needs.

    In summary, here is kind of how I boil down the issue:

    1. Should capital gains have a differential tax rate than ordinary income? If you think not, then the rest of this issue is moot. If you think it should, because it stimulates a higher rate of capital formation and velocity of investment in the economy – which I believe it does – then move on…

    2. Should capital gains tax treatment apply narrowly only to the investment of actual cash, or can it also be applied to the creation of wealth via the growth in value of capital assets (i.e. things that are bought and sold as capital assets, which separates it from things like sales commissions)? I.e. if you start a restaurant or a farm or a business or an natural gas well or an apartment complex, and you put in a small % of the $ but do all the work and own a large % of ownership of the asset, while others supply just the $, are you limited to capital gains tax treatment on just the $ you put in, or should you eligible for capital gains tax treatment on your entire share of ownership in the asset that you helped to build? If you think the answer is that cap gains tax should only apply to cash, then we’re done and the rest of this is moot. I believe, however, that it is reasonable for the government to adopt a tax policy – from a practical, if not a philosophical or ideological standpoint – that incentivizes such entrepreneurs, as it is one of the key ways our economy has remained vibrant. If you agree with me, then I would also argue that people who start technology companies, or people who work for them, ought to be entitled to similar incentives of capital gains tax treatment on the increase in value of their ownership stake, and not just the de minimus amount of $ they may have directly invested themselves.

    3. If the government tax policy is going to incentivize the creation and long-term growth in value of capital assets in the form of restaurants, farms, wells, properties, and technology startups – and do so in a way that applies the capital gains tax incentive to the ownership stake of the owner and not narrowly to the $ they invested – then the next question is, who should be eligible for that incentive? Until now, the answer has been pretty clear: the tax applies to the ownership in the asset, not to the cash contribution, so if you build a great restaurant or farm or business or property, and sell it, you get capital gains treatment. Under the new proposals, however, you’re now looking at a different approach. So the question is, how do you decide who should be eligible, if you’re not solely relying narrowly on cash $ invested? If you think it should just be founders, or just employees, then what about companies that angels or VCs help found, or take a interim operational role with? Practically speaking, I think it is nearly impossible for the government to draw distinctions among different types of non-cash contributions to the growth of value of a capital asset, and I think the only way to do it is how we’ve historically done it: we let the people involved neogitate among themselves how much ownership will go to those providing intangible value and how much ownership will go to those providing cash. If you and your uncle agree that he gets 80% or 99% or 60% of the restaurant’s ownership for providing nearly all the capital, and you get the rest for working the 90 hour weeks, I argue that ought to be up to you to negotiate and not have the goverment awkwardly intervene with a tax policy that tries to define differently who is doing what. That said, it’s perfectly reasonable to argue against my position here; I’m just saying, I don’t think it’s practically reasonable to argue against it purely on the limited case of how VC carried interest is treated, without thinking about what happens to treatment of all the other deal structures and players throughout the small business and entrepreneurial economy, because I don’t think it’s possible in the end to differentiate them.

    4. Finally, if you agree from #1 that it’s good policy to tax capital gains differently than ordinary income, and from #2 that it’s okay to apply cap gains in some cases to situations where the capital gain was created from an intangible contribution, and from #3 that it’s okay to allow individual players to negotiate their share of the cash vs. intangible contribution, then we end up in a final question of whether or not this practical “technology” of a policy approach, as opposed to a philosophical or ideological approach, ends up creating more benefit or less. Here, you simply have to decide, do you believe some version of the many studies that show the enormous benefit to the USA economy and private sector job creation from having incentives to the various players who support non-leveraged, long-term, high-risk start-up company growth? If, like some bloggers, you simply think it’s all baloney and PR hype, then it is reasonable to argue that the government shouldn’t bother to stimulate this area. (You probably think they should do more to pay farmers not to grow corn). If, like me, you think that the directional trend of all the studies is pretty conclusive, regardless of any quibbles about particular numbers and particular metholdogies, then I would argue that it’s pretty damn important for government tax policy to do everything it can to incentivize this type of company growth, recognizing that more often than not, the entrepreneurs and the investors and the employees come away with nothing, but when it does work in the minority of cases, it works so well that it has literally driven nearly all of our country’s economic and productivity gains in the last 30 years.

    So, there’s my long-winded articulation of how I see the world. As always, your mileage may vary and I respect the opinions of well-mannered people committed to thinking the issue through.

    • Matt

      You've convinced me,Trev mostly from the point of view that it would be operationally difficult to make the distinction between value created thru intangible contributions – ex founders and GP/VCs – because that distinction would have to be made if the strict definition of capital gains treatment only for invested cash is used. Rather than follow that path into the land of unintended consequences, I would retain the status quo. Bottomline means I would rather continue giving VCs an unneccesary benefit rather than risk taking away the same benefit from founders and entreprenuers. One argument from Jason which I dont buy is that VC investment would move overseas if the change in tax policy were to happen. As USA citizens, wouldn't their carried interest still be taxed per government policy regardless of where such "income" was earned (domestic or overseas)? In any case, VCs go where they can make their returns; they arent investing in USA out of love or loyalty- theyre here now because this is where the ideas and returns are biggest and surest. I think Jason was basically staking out an emotional position and convinced himself it was logical. You saved his ass.

  • Bill Burnham

    Looks like a deal has been cut:

    "The bill would prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as carried interest in an investment fund. To the extent that carried interest reflects a return on invested capital, the bill would continue to tax carried interest at capital gain tax rates. However, to the extent that carried interest does not reflect a return on invested capital, the bill would require investment fund managers to treat seventy-five percent (75%) of the remaining carried interest as ordinary income. A transition rule would apply prior to January 1, 2013. This proposal is currently being estimated by the Joint Committee on Taxation.”

    Not sure what carried interest on invested capital is, I suppose that is returns on the GP fund investment and if so that doesn't generate carried interest anyway. As to carried interest on GP commitments it looks like they just decided to tax it at ordinary income with an arbitrary 25% discount in order to get the deal done. Gotta love politics!

  • If the government tax policy is going to incentivize the creation and long-term growth in value of capital assets in the form of restaurants, farms, wells, properties, and technology startups – and do so in a way that applies the capital gains tax incentive to the ownership stake of the owner and not narrowly to the $ they invested – then the next question is, who should be eligible for that incentive? Until now, the answer has been pretty clear: the tax applies to the ownership in the asset, not to the cash contribution, so if you build a great restaurant or farm or business or property,

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