The U.S. Congress has many mouths to feed. From programs that fund health care to fixing the AMT so that unintended taxpayers are not swept into that paradigm, most members of Congress, for better or worse, believe they need to find additional revenue streams. Identifying “tax loopholes” has always been among the first choices to explore.
As we enter the summer months, lawmakers appear to be initially casting a wide net in order to bring in a veritable bounty. However, care must be taken to ensure that the wrong fish don’t accidentally get caught in that net—especially those that help bigger fish grow and generally improve life in our economic waters. Judging by recent discussions on Capitol Hill, the carried interest earned by venture capitalists could indeed face just such a danger.
Currently, the U.S. taxes carried interest on a flow-through basis from a VC fund, generally resulting in taxation at the long-term capital gains rate. When one considers the structure of the VC model, the risk involved, and the long time horizon for realizing these gains, this tax rate hardly rates as a loophole.
Consistent with historical partnership tax law, the VC fund structure encourages the pooling of labor and capital by allowing its partners to divide the profits from the enterprise—whether created by the VCs’ services or the LPs’ capital. These partners decide what is appropriate to reward the entrepreneurial risk taken by each partner.
This risk is always significant. The VC industry focuses on innovative, high-risk technological advances. That many VC-backed companies fail is simply part of the process. As a result, a VC fund pulls up many empty nets, the cost of which must be recouped by its successes.
Finally, the time horizon on these investments lasts much longer than those investments associated with intra-day trading and other alternative investment vehicles. If they turn a profit at all, most funds don’t do so until late in their 10-year life spans, as the VCs involved nurture these startups to the point where they can enter the public markets or be acquired.
By correctly permitting carried interest to be taxed at the capital gains rate, the United States has enabled the venture capital industry to generate 10.5 million jobs and $2.3 trillion in revenue.
Mark Heesen, President, National Venture Capital Association
During this time of nurturing and guidance, venture capitalists typically earn a 2% management fee that is guaranteed and calculated annually as a percentage of the fund’s total capital committed by its investors. This fee, which often declines over the term of the fund and is used to pay for the VCs’ business operations and the entire firm’s salaries, is taxed as ordinary business income. The salaries are taxed as ordinary compensation income, and are subject to employment taxes.
The primary economic benefit generated from the fund—the carried interest—comes much later, if at all. In some cases, VCs pay tax on this stake even before they are entitled to the cash attributable to the carried interest profits. By just about any measure, startups are risky, long-term investments. For this reason, most of a VC fund’s income is characterized as long-term capital gain. This treatment is consistent with the long-term capital gain treatment afforded a corporate founder who took a lower salary in exchange for founder’s stock in that same startup.
So far, Congress has gotten this right: By correctly permitting carried interest to be taxed at the capital gains rate, the United States has enabled the venture capital industry to generate jobs and revenue (10.5 million and $2.3 trillion, respectively) that have been significantly disproportionate to the share of GDP (0.2%) devoted to it. In the process, venture capital has spawned some pretty big fish—Apple, eBay, Federal Express, Google, Microsoft, Staples and Starbucks—and a global competitive advantage that has helped countless other companies.
For the U.S. to keep this edge, Congress must continue to recognize long-term capital gains when it sees it, and realize that it has bigger fish to fry, perhaps a tad further “off shore.”
Mark Heesen is the president of the National Venture Capital Association. He can be reached at email@example.com.