Carried Interest Tax Debate and why should startups care?

Unless you were caught up in the iPhone hype or busy with the Paris Hilton saga, you are probably familiar with the “Carried Interest” Tax Debate in the VC community.

In a nutshell this is what the issue is and let me illustrate it with a concrete example:

Let’s say Frank wants to start a new venture fund; he calls his friends and other investors and raises $50M. Frank is the general partner and the other investors are limited partners. Frank’s compensation is some management fee, plus a portion of the “up side” of the fund. If the fund gains by 10%, he doesn’t get anything, but if it gains by more than 10%, he gets 20% of the increase, i.e., if the fund gains by 15%, Frank gets (20% of extra 5%) which is 1%. Different funds have different numbers and different thresholds, but the concept is the same.

Under the current tax code, the 1% that Frank gets (his “carried interest”) is treated as “capital gains” and it gets taxed at the rate of 15%.
Under the new tax bill that is afoot, the 1% will get taxed at the rate of personal ordinary income tax, which is about 35%.
The investors (limited partners) will continue to get taxed at the capital gains level of 15%, only the general partners (Frank in this case) gets taxed at 35% for his portion.

And why does Congress want to pick on Frank, the general partner here? They put forth two reasons: the first one, in a nutshell is “Frank made a lot of money and we want some of it”; and the second argument goes like this: “Hey, Frank didn’t put up his own money here; why should he get capital gains treatment, its all income to him! - lets get him.”

To show that this is all really asinine; lets take another example. Frank now wants to start a Pizzeria, he calls his friends and investors and they put up the money. They agree that the investors will own 80% of the business and Frank will own 20% of the business. Frank works hard and in a few years the pizza place is a great success. The pizzeria is sold for a handsome profit. Now for the questions - the 20% that Frank makes, is it ordinary income or is it capital gains?

If you get options at the company that you work for and if you hold them for a while and the options increase in value - is that ordinary income of capital gains?

In neither of the cases above, the person getting the “capital gains” tax rate, put up any of his own money. But we all know that in both of these cases, the increase in value is “capital gains”. All parties contributed to the success of the enterprise, they all took risks. Some brought in money, others brought in expertise, and some brought in know-how.

To me, these are simple partnership issues; if the underlying asset qualifies as “capital gains”, then for each of the partner; it is “capital gains.”

And what kind of logic is it to tax somebody more, just because they succeeded! Venture funds have contributed so much to the economy; they should be rewarded not punished. Moreover, the equity managers are generally in control of their own taxation, before the ink on the amendment is dry, there will be new methods devised, new Blocker Corporations setup to ensure that the carried interest gets treated at 15% (or even less) rate.

How does this affect the startups and emerging companies? It affects them directly. If Frank gets taxed at higher rate, he will either charge higher management fee or increase his carried interest so that he comes out even. And people who get less are the investors and that means they will be less likely to invest. The next time you have a Web 3.0 epiphany, you might not find as many people wanting to write you a check.

The place where the effect will be most directly seen would very likely be in “smaller markets”. The Silicon Valley, the southern California, the New England area, all of them will continue to get funding; managers will continue to manage, but when somebody wants to start a regional fund for North Carolina research triangle or for the Energy Corridor in Houston, the venture funds and the catalysts that make the funds happen, will be less likely to be there.

VCs have provided one of the most important economic engines in recent times; lets keep it moving and not burden it with more taxes.

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3 Responses to “Carried Interest Tax Debate and why should startups care?”

  1. By fred wilson on Jul 15, 2021 | Reply

    Sunny,

    I am not sure this is entirely correct.

    I believe that most options proceeds are taxed as ordinary income not capital gains under current tax law.

    also, if the pizza owner puts up $1000 to start his pizzeria and his investors then put up the balance of the money, he will get capital gains treatment if the pizzeria is ever sold.

    finally I do not believe changing the tax rates will have any impact on the amount of equity the entrepreneur has to give the VCs. It’s a market ecconomy and the entrepreneurs that have attractive businesses will always be able to negotiate market rates for their transactions.

    Fred

  2. By Sunny Kalara on Jul 16, 2021 | Reply

    Hi Fred!

    I have followed your blog with great interest; what I like about your blog is that you recognize what is “bubbling” and always bring in a fresh prospective.

    Regarding the options; as I mentioned in the blog, the comparison is with the kind of options you get when you work for a company and you hold the options for a while, commonly referred to as the Incentive Stock Option (ISO). In both cases the management/founders are taking the risk - the same risk that the VCs take. For ISO, they receive the Capital Gains treatment. A general purpose article on this issue is here.

    As for the pizzeria example, $1000 to start depends on the shares that are priced when the company is formed, and it could be just a nominal penny. The point here is that all the share holders should get the same treatment - the share holders that wrote a check for $$$ and others who put in different types of resources. If the underlying transaction qualifies as a transaction eligible for Capital Gains treatment, then it should be the same for all that took the risks.

    On the question of impact, you are absolutely right that the attractive businesses will always be able to negotiate market rates for their transactions, and that’s why I think it would have limited impact on places that have a track record of producing robust businesses. But it would have impact on the “market rate” for businesses that are or are perceived to be on the border line.

    It will change the criteria employed during the due-diligence; it will affect the “back track calculation” of what do we need to get to make this worth while and that ultimately hurts the startups.

    Another related point is that here we are discussing the impact of “taxes”. Taxes “distort” the market economy and prevent transactions from fully allocating the true economic benefit to each participant. The suggestion here is that there is no reason to add yet other distortion to the system in terms of higher taxes for the general partners of a VC fund.

  3. By Andy Gottlieb on Jul 17, 2021 | Reply

    Two economics points to add to the discussion which I’ve yet to see anywhere in this debate:

    1) Options *are* effectively treated as capital gains by the ordinary tax code. But most options gains of any magnitude end up being taxed at the higher (26%? 28%) AMT rate, I believe, because under AMT they are ordinary income.

    2) Any taxation of capital gains causes negative economic distortion. So does taxation of labor (i.e. “ordinary income”). But even we economic conservatives believe that some level of taxation is reasonable, and until the day we move entirely to VAT (which has issues of its own) as the primary means of government fund raising, we’re going to have income taxes, and we live with having capital gains taxes. The key point in this debate is the delta between the two.

    If we had a flat-tax (flatter tax) with lower marginal rates on “ordinary income”, then the issue would go away. I.e. strip out the deductions for most things (except cash charitable contributions and mortgage interest up to some per state median maximum), and lower marginal income tax rates. We can all argue what that rate should be: 25%? 23% ?? 27%?? Whatever. Steve Forbes had this one thing right.
    Politicians hat doing this because it strips their power - tinkering with the tax code being one of their biggest levers. But besides being “fairer”, simpler and less corrupt, simply having lower marginal rates is the right thing to do for the economy on many other levels. And once you’ve done it and narrowed the delta, then the passion on the issue should go away, whichever way it’s resolved.

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