Carried Interest Tax Debate: Here We Go Again

President Obama released his FY2013 budget plan on Monday, February 13, 2012.  As expected, it contained the usual assaults on the 1% of taxpayers (Adjusted Gross Incomes above $344K) who are already paying close to 40% of the total personal taxes collected.

One of the “usual suspects rounded up” was taxing Carried Interest at ordinary tax rates rather than the capital gain rate.  Carried Interest is the amount of gain that an Investment Firm (Venture Capital, Private-Equity, Buyout Firm, Hedge Fund, etc.) gets to keep on a successful investment and distribute to its employees.  It is usually 20% of the gain.

So, if the Firm invested $1M in a business and after several years, cashed out of this investment by selling its share for $3M, there would be a $2M gain.  The Investment Firm gets to keep and distribute to its employees 20% or $400K of that gain. The remaining 80% or $1.6M of the gain is distributed to the Investment Firm’s investors (pension plans, endowments, high-net worth individuals, etc. – called Limited Partners or LPs)

Under current tax law, this $400K distribution is taxed to the employees as a capital gain at 15% and the tax is $60K.  Under the Obama proposal, this gain would be taxed as ordinary income.  Assuming the top rate of 39.6% (Obama FY2013 Budget), that bonus would cost the employee $158K in taxes, an increase of 164%.

The argument for taxing this gain at ordinary income tax rates is that the funds used for this investment were contributed by the Investment Firm’s investors, not the Investment Firm’s employees.  Therefore, these employees did not have any money at risk.

Now, we do not have a “horse in the race” here, as we are not an Investment Firm, but feel taxing carried interest at ordinary income tax rates, especially for Venture Capitalists (VC), is very unfair.  Our reasons:

• The typical VC is paid somewhat modestly (taking into account their education, experience, and other employment opportunities available to them).  According to salary.com, below is a chart of their median annual salary and bonus (we will assume this bonus is from the carried interest):

• Assuming these amounts are somewhat reflective of reality (and we do understand that these are median amounts and that some VCs earn considerable more than these amounts), carried interest represent about 41% of an experienced VC’s total compensation versus only 12% for an entry level VC.
• Therefore, if there is any fallout from this tax change, it will be the more experienced VCs leaving the industry or retiring.  In our opinion, this can be harmful to the VC industry and the US economy for the following reasons:
  • More experienced VCs make better investment decisions (for obvious reasons).  Therefore, fewer successful companies will be funded.  Thus, there will be fewer US jobs created.
  • VC firms and the VC industry are dependent upon their LPs to continue to allocate a part of their portfolio to Venture Capital investments.  If VC firms cannot raise money for new funds because of this “brain drain” fewer companies will be funded and fewer US jobs will be created.
  • If VC firms raise their carry to 30-35% to compensate for increased taxes, the returns for LPs will decrease, forcing them to allocate less of their portfolio to VC investments.  Thus, fewer companies will be funded and fewer US jobs will be created.
• VCs invest in start-up firms that often take five to ten years to mature before they can be taken public or sold.  VCs are not passive investors.  They are actively involved in their portfolio companies, yet there is a high probability their investment will be worthless, due to the high risks inherent in these start-up companies.  Thus, their risk and reward reflect sweat equity that should be treated as a capital asset.
• The employees of the companies that VCs invest in receive capital gain treatment on their gain from stock options and stock ownership.  Treating carried interest as ordinary income would unfairly tax an equivalent gain by these VC employees at a rate that is 164% higher than the employees of the portfolio companies.
• Unlike many Hedge Funds, the carry in a VC firm is accumulated and created over many years which is one of the requirements to receive capital gain treatment.  Hedge Funds often create value in a very short-time through high frequency trading or derivatives, which is regarded as ordinary income.
• Assuming no changes in the current tax system, capital gain rates will increase to 18.8% in 2013 due to the 3.8% Federal Tax surcharge for unearned income, including capital gains as a result of ObamaCare.  Therefore, the Treasury will already receive 25% more in tax revenue from this carried interest.

In our opinion, the Venture Capital industry has created millions of good paying American jobs and this Administration and President are totally out of touch penalizing the talent in this industry for being successful.  Doing so, will result in fewer good paying US jobs being created and be harmful to the US economy.  Also, we feel that more money in the hands of taxpayers, rather than in the hands of politicians, is a better way to stimulate our economy.

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IRS Circular 230 Disclosure

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.

Filed under: Blog, Tax.