The last week or so has brought a ton of posts and commentary regarding the issue of taxing the carried interest that VC’s generate from successful investments.
Of late the topic has gotten heated – and the remarks have gone from the benign to the belligerent.
My own take on the matter is that people are confusing several interlocking issues – and getting all heated up about it without really understanding or thinking through the facts and the implications of any changes.
Fred Wilson started the ball rolling at AVC with his post on the subject over Memorial Day weekend – here. His basic premise is that the carried interest is a fee and thus should be taxed at ordinary income levels – as that is a fair way of looking at the tax. Others have weighed in in favor of the increased tax – most prominently Chris Dixon here. The naysayers on the tax have come from all angles, but prominently Jim Robinson of RRE here, Jeff Busgang here and BillBurnham here.
All of these posts – whether for or against the higher tax rates for carried interests are well written cogent arguments. What is really impressive however, is the comment threads on these posts which run to hundreds of comments – and are heated to say the least (and thus very well worth the time to read them all). So much so that Roger Ehrenberg today penned a piece talking almost solely about civility on comment threads – using this debate as an example.
Before getting out the scalpel and dissecting all the issues – let me state upfront that it is only because the US has such a great entrepreneurial spirit and culture that we can even have this debate. There’s a reason “Silicon Valley” and the VC system exist in the US like nowhere else – and there is a reason why we an have debates on start-up visas etc… There’s no doubt that we have to pay for the privilidge of living in such an opportunisitic society – but how we pay – and how much is the question that is really open to debate.
So to it:
The carried interest is a fee. No mistake about it. Unlike a management fee (now typically 2% in VC, hedge funds and private equity shops) it is different in that it is a fee paid solely upon the successful sale of an asset after a period of investment. It is thus and artificial construct of the original partnership accounting rules under which almost all private investment partnerships are governed. Invest in an asset and hold it for a certain length of time (1 year for a company – 5 years for a home – assuming you have lived in it) and you qualify for a lower tax rate. As Fred Wilson replied to a comment on Chris Dixon’s blog, “you play the game by the rules that are in place. if you don’t like them, you try to change them” Fair enough. For years the rules have been pretty clear – hold an asset in a partnership for a certain amount of time – and if there is a gain, then someone with a carried interest in the partnership gets paid their fee as a slice of the partnership – retaining all of the tax characteristics of that partnership.
So here we are now intensely debating whether it is fair to change the rules – and in essence – double the tax on the carried interest from 20% (assuming the Bush tax cuts are allowed to lapse) to roughly 40%.
I’ll skip the details for now – but my view on this concept is that if the government sees fit to tax VC’s, hedge funds, and PE firms at the higher rate – then everyone should be taxed at the higher rate on capital gains. When you start breaking down taxes based on the perceived success of a class of business – you are starting to set dangerous precedents – and really starting to eat into the framework that makes the US such a great place for investing.
As Fred puts it, it is a matter of fairness. I always thought fairness meant that everyone got treated equally. To me that is fair. As your kids what is fair. If you have 2 kids and two ice cream cones – they’ll tell you that it is fair that they each get one. If there are 4 dishes on the table and they are going to clean the table – fair means that each one is clearing two plates. You never hear them claim that one is bigger than the other and therefore should carry 3 plates because capacity is the issue.
Fair is equal.
The media has gotten away from that in talking taxes. In the mainstream media – fair means paying what you can afford – and what you can afford is generally determined by someone who is being subsidized by someone else. When the head tax writer of the House (Charlie Rangel) can’t pay his taxes like everyone else – and the Secretary of the Treasury (Tim Geithner) can’t pay his taxes fairly – is there any wonder why this debate has gotten so vitriolic. Everyone loves the American way – and everyone understands that there is a bill to be paid – so how do we fairly split the check?
This populist sentiment has extended into the capital gains treatment for the sale of stakes in VC shops along with hedge funds and PE firms – and this is clearly wrong in my opinion. Why are these entrepreneurs any different from anyone else? They founded a business, they took risk, they paid taxes at the prevailing rates – and if they should decide to sell, why is that any different than when a start up sells to Google? Why should it be treated any differently? Of course it shouldn’t.
Strangely, you haven’t heard much about this part of the debate – largely because VC firms just don’t sell. They are a collection of individuals with little ongoing equity value in the firm without the founders. While there have been some hedge funds and PE firms that have either sold stakes or gone public – they are the exception – and anyone big enough to really enter into one of these transactions has likely accumulated enough wealth that in this environment it has just become unseemly to complain in public. Am I worth $300M or $400M is not a question that is going to get a sympathetic hearing.
You do, however, hear about whether angels should be taxed differently. The argument goes that angels are smaller – make no money on their management fees and thus have to rely on carried interest – so don’t tax them as much. Of course, this is a facetious argument. No one demanded that they become angels and keep their business small – and no one told them they could not scale it to become bigger and institutional. If you are good enough to be a successful angel – chances are you are good enough to join or grow a much bigger entity – but chances are that you like working with smaller companies at the formative stages – and you don’t want to be beholden to institutional investors – and deal with a mess of partners all competing for capital – and for this reason you remain small. It is a business choice with a real trade off – you have to be right more often.
So what’s really going on here?
We’re not really debating as to whether or not the carried interest is a fee or not. And we’re not debating whether it is right or wrong to raise the tax on it.
What we are really debating is tax fairness – or more properly put – the level of transfer payments from those who have the most to those who have the least.
And why are we having this debate?
I would argue that we are having it because we have a spending problem – not a revenue problem – and the political cost of fixing the spending problem is too high for politicians to tackle – and thus we resort to populist measures like raising the level of “fairness” in the system. When entitlement spending – be it social Security – Medicare – Obamacare – Public Pensions – are out of hand, and cutting them is political death – you can be guaranteed that the politicians will “kick the can down the road” and tax whoever they can to live to fight another day. If they can do it in populist way “don’t tax me – tax that banker behind the tree” – all the better.
We would all be better off if we just tacked the problem once and for all – and fix the issue.
Since we are not going to do that, by all means raise the carried interest tax – but do it fairly – by raising it for everyone across the board – or by changing the partnership accounting rules – and by no means tax the capital value of fund managers who built up their companies.
Let’s not disincent success – or at least if we are going to tax success to pay for an untenable future – let’s do it evenhandedly.