Rewarding High-Risk Innovation: The Case for Carried Interest
As Washington grapples with the deficit, nothing generates more emotion than tax “loopholes.” A priority “loophole” target in the budget that President Obama sent to Congress last week is the treatment of managers’ carried interest in private equity funds as capital gains, which he characterizes as “unfair” and the key reason for the low tax rate paid by Mitt Romney.
When John Steele Gordon declared “Carried Interest is not a Capital Gain” in a recent commentary for the Wall Street Journal, he drew a slew of comments, most of which supported his view. Some were downright virulent, as in, “These vultures are leaches who will eventually ruin our economy. No way they should get a huge tax break for doing it.”
Before changing the rules in this area, I suggest that we consider the argument for capital gains treatment, particularly in the case of venture capital funds. I have a vested interest in the issue. I am a life sciences venture capitalist.
In the article Gordon explains that “Managers of these funds are compensated for their services in two ways. One is the annual management fee, usually 1 percent or 2 percent of a client’s investment. The other is a share in the net profits of the fund’s long-term investments. …The management fee is taxed as ordinary income, but the long-term profits of investment are taxed as a long-term capital gain, for both clients (the investors in a venture fund) and…managers.”
Gordon contends that fund managers should not be entitled to a break, because they “share in the gains but not the losses. They do not put their own money at risk; the reality is that the compensation for their services is income and should be taxed as such.”
Gordon agrees that an entrepreneur should be entitled to capital gains treatment, because “he invests his time and his sweat equity… He is risking a lot: a substantial portion of his working life, his reputation, his potential current income, etc.” All a fund manager provides is advice, like a lawyer.” (That last analogy is particularly painful.)
Mr. Gordon’s descriptions of a founder pretty well describe the contributions of an early stage venture capitalist. These fund managers go through the same process as any founder, starting with an idea, organizing the company, raising funds and recruiting managers.
Venture capitalists clearly meet Mr. Gordon’s two principal requirements for capital gains treatment: Sweat equity and returns at risk. However, a venture capitalist faces an additional level of risk. Before he can take a share of the profits from any one investment, he has to repay the costs of all the other investments in his fund, plus all of the fees he has received. In fact, if the venture team had received options to purchase a 20 percent interest in the fund instead of a carried interest, they would be in exactly the same position as a management team granted stock options, which all agree qualify for capital gains treatment.
John Carey, senior editor at CNBC.com, points out that managers of private equity funds rightly expect to be taxed on the same basis as their investors, because the rate should be based on how the money was made—through investing in long-term assets—and not who received it. “In fact this [discrimination between investors and managers] seems a bit unfair: it rewards those who already possess wealth and punishes those who must raise it from others.”
While meeting the technical requirements is important, an even more compelling argument for capital gains treatment is the benefit to society of incentivizing venture capitalists to pursue the often quixotic task of starting new companies.
Before they can share in … Next Page »