
House Backs Tax Increase for Venture Capital - jlhamilton
http://bits.blogs.nytimes.com/2010/05/28/house-backs-tax-increase-for-venture-capital/
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grellas
VCs have a special stake in this particular debate and find themselves in the
minority in an environment when everyone is howling for the heads of all those
who manage private equity funds. And "carried interest" does indeed represent
a type of gain that probably can be fairly classified as being (1)
attributable to the sale of a capital asset and hence eligible for capital
gains treatment or (2) attributable to services performed by a GP in managing
a fund and not tied in any significant way to capital actually invested by
that GP in the asset being sold.

This Congress says the tax is for services rendered and should be paid at
ordinary income tax rates (actually, 75% of carried interest will be taxed as
ordinary income and 25% as capital gains - and there will be a phase-in to
boot, so that the full impact will not hit the VCs for some years). Prior
Congresses have disagreed.

Make no mistake, though, that the issue here is _not_ one of merely closing a
loophole. This Congress believes _philosophically_ in raising taxes to pay for
its expansive spending proclivities, and it is looking to do that in more ways
than one. VCs happen to be a big, fat, and unpopular target in this instance.
Private entrepreneurs will be next.

For this reason, among other things, this Congress will make sure that it does
nothing to block the automatic increases scheduled to go into effect January
1, 2011 (LTCG from 15% to 20% and top bracket on ordinary income from 35% to
39.6%).

Now, any one of us may or may not be bothered by this depending on our
particular view of the role of government, the importance of a social safety
net, and the part taxes should play in funding these social aims. Indeed, we
may see these developments as a positive good in changing the balance between
government and private enterprise. That is basically a political and
philosophical issue.

But do realize that this sort of expansive view of taxation, as applied here
to the VC's "carried interest" gains, could just as easily be applied to
founders who put no (or trivial) cash into a company up front and yet profit
from the ultimate sale of equity that they get up front as they found their
companies and then devote years of service to building its value. While it
might be shocking to contemplate, if one were philosophically inclined to do
so, there is nothing stopping a future Congress from saying - based on a
direct analogy to the logic being applied here to carried-interest taxation -
that the gains of such founders are really more attributable to their services
than to any capital investment and hence should be taxed at ordinary-income
tax rates (or maybe at some hybrid rate such as being applied here to the VCs,
such as 75% at ordinary income tax rates and 25% at LTCG rates). In this
sense, startup founders typically are no more investing "capital" for their
stock than a GP is investing capital for its "carried interest" share.

I realize there is no risk of this type posed anytime soon to founders. But,
_logically_ , there is little difference between the two cases and what is
regarded as the founder's perk of today might, with passage of time and a new
political environment, just as easily become the "loophole" of tomorrow.

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tptacek
If I understand this correctly, the loophole that's being closed here is a
special tax rate for "investment income" from money that did not expose the
VC's themselves to risk, but only the VC's limited partners (who provide most
of the capital for venture funds).

In other words, the pension funds, endowments, and corporations that actually
_provide_ capital aren't being taxed more aggressively. The people who
allocate that capital are.

This makes sense, doesn't it? If you invest $10,000 of your own money in a
company for several years, you should rightly expect to pay the long-term
capital gains rate on the returns. The tax code wants to encourage you to
invest in things and drive the economy, and you did that.

But if I give you $10,000,000 to invest for me, and you turn it into
$50,000,000, you shouldn't be getting a free ride on the millions of dollars
you just made. The money was getting invested one way or the other. All you
did was make it your job to invest it (allegedly!) efficiently.

~~~
sachinag
Every single GP will admit it's a total giveaway when they're drinking and
amongst their kind. How do I know? I've been drinking with many in my time as
an investment banker, junior VC employee, and "trusted" entrepreneur.

You know what's worse? The PE guys and the hedge fund managers get this
treatment on carried interest too, but they know there's absolutely no way to
justify it and so they're letting the NVCA stick up for all of them. There are
_massive_ amounts of money being funneled by members of the Private Equity
Council into this debate that no one is seeing.

~~~
huangm
Hedge fund incentive fees are taxed as ordinary income.

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Serene
VCs are already investing more of their capital off-shore, this bill would
further discourage them from investing in US startups.

~~~
kgrin
As others have pointed out, this has little to do with the capital itself, but
with the compensation that VCs get essentially as money managers. So the
impact on actual investment is likely to be close to zero, even if there are
reduced incentives to _being_ a VC. Look at it this way - if a plague struck
and killed one of every 10 VCs, chances are that the amount of capital
wouldn't radically change - it would just mostly get reallocated among the
survivors (I'm sure it would change in some marginal case, it might depend a
bit on who the affected VCs were, etc.)

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stretchwithme
boy, do we need tax simplification. all of this micromanagement of our lives
isn't sustainable.

I doubt if anybody could determine the total cost to the economy. Of course,
costs aren't anything lawmakers are concerned with.

~~~
tptacek
It would simplify the tax code not to carve out special exemptions for venture
capitalists.

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jonmc12
“It is both ironic and disconcerting that legislators can profess commitment
to creating jobs — and then discourage the type of long-term investment which
has been a proven job creator for the last century,”

.. this is only true if you can show that VCs create more jobs than an
alternative investment of the same capital. Is there any data on this?

~~~
tptacek
Probably not, but there's rumblings about the poor relative performance of VC
as an asset class in general (ie in returns relative to illiquidity) --- and
investment in, say, corporate bonds _also_ funds business expansion.

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akikuchi
Anyone interested in reading more about this should check out this paper that
was fairly central in advancing the debate over the last four years. It's an
interesting read, and highlights some of the challenges with matching tax
policy to desired outcomes. <http://victorfleischer.com/archives/80>

Also, this is an interesting blog archive from when the author of that paper
was a regular contributor, as the debate picked up in 2006-2007:
<http://www.theconglomerate.org/taxation/page/3/>

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yanowitz
It's about time. There's nothing like a fiscal crisis to get a few tax
loopholes closed.

