VCs Cry Boo-Hoo, Refuse to Pay Income Tax

As Adam Lashinsky reports, a collective whine is rising from comfy VC offices as Congress contemplates the possibility of--horrors--making venture capitalists live by the same tax code as everyone else.

The issue?  Thanks to the mountains of money private-equity firms have made in recent years, the industry has been attracting scrutiny, and someone noticed that private-equity firms, VC firms, and other "alternative" investment entities have for years enjoyed a sweetheart tax deal: The firms' performance-based fees (often 20% of profits) are taxed at long-term capital gains rates rather than ordinary income rates.  The logic behind this treatment is flimsy at best, but it was probably made possible by the genius who labeled such fees a "carry" instead of "fees."

In any case, Congress is now considering making VC and PE firms pay regular old income taxes, a move that makes perfect sense to everyone except the VCs.  The VCs, meanwhile, are trying several tactics to preserve their dream rates, including hiring lobbyists, making unctuous arguments that--unlike bloodsucking PE firms--they develop businesses and create jobs (so do working stiffs), and declaring that their performance-based fees are actually capital gains.  Some VCs have even suggested that, if the tax-treatment is changed, the economy will suffer and they'll quit the business.  (This last sentiment is particularly absurd: What are they going to do when they quit--go work in other, less-interesting, lower-paid businesses where people already pay income taxes?)

According to Adam, the VCs make two basic arguments about why their fees are actually capital gains:

1. The fees take a long time to earn.
2. The fees are performance-based.

Well, so what.  Incentive comp is still comp.  In the real tax world, meanwhile, it doesn't matter whether you provide your services for one day or ten years.  A contractor who gets a lump-sum payment after a decade-long construction project pays income taxes, not capital gains.  Employees who exercise and sell incentive stock options pay income taxes, no matter how long they've held the options.  Etc.

The one argument not made about the tax treatment is the only one that would be valid: That VCs actually put their capital at risk.  VCs don't put their capital at risk--they get paid to put other people's capital at risk.  (A new law would presumably not affect the tax treatment of capital that partners have invested in their own funds--which would be capital gains).

VCs have enjoyed favorable tax rates for years, and no one can blame them for hoping the gravy train will continue.  There's a difference between quietly hoping and making embarrassing, self-serving arguments, however--especially when VCs can lock in great tax rates forever just by investing in their own funds.

Comments

[Victor]

This is a classic case of "it's not my money so I don't care if we tax it". I think we should tax the hell out of sanctimonious bloggers.

[curmudgeonly troll]

A better question is why capital gains are taxed at a different rate from income.

If I own a hot dog stand, should I get taxed at a high rate if I take a salary, at a low rate if W 57 St Wieners pays me a dividend or 'capital gain' on purchase and resale of the hot dogs?

The whole system is nothing but a full employment act for accountants, lawyers and lobbyists, better blame them than the sharp investors who take advantage.

[Henry Blodget]

I'm not blaming VCs for taking advantage of the loophole--I'm blaming them for complaining that it is unfair that the loophole might be closed.

[Alex]

.....if the tax-treatment is changed, the economy will suffer and they'll quit the business.

1) "economy will suffer": hello! is anyone home. They are nutz.
2) WOW! this is like professional athletes saying the same thing. Imagine, getting real jobs and earning $90,000/year versus earning in some cases $20M+/year.

Should the tax rates increase you can bet that the VC snakes will look to increase the carry fee to new heights in order get back to par. Oh ya, they will also increase the mgnt fees.

[Tom]

As a point of interest, does the same reasoning hold for hedge fund managers and suchlike?

[james]

Your dividend from 57 st. Wieners would be taxed as income. Of course, you can move to the UK where there is no such thing as a short term capital gain...and effectively, you tax rate on gains is your income tax rate....and you get to do it at a higher rate than in the states to boot.

All this winging about paying taxes from the super rich is nauseating. A friend working at a wealth management firm says the last month of the tax year has him busy every time clients who are more interested in learning how to minimize their tax payments rather making more money. It's like a psychosis.

Here's a different take for these folk. Appreciate your taxes. (Even if you don't agree with the way every penny is spent!) They are the price of civilization. If you lived in a place for a while where tax enforcement was lax, you'd soon appreciate just how important they are, especially if you are rich; for the lucky few (be they members of the lucky sperm club, or fortunate enough to have made a pile out of the sweat of their brow) taxes are what keep the masses from ripping their heads off in the street. (Even if you don't agree with the way every penny is spent!)

[curmudgeonly troll]

Ummh, James, perhaps you meant dividends should be taxed as ordinary income, but they are not. To wit Wikipedia:

In 2003, President George W. Bush proposed to eliminate the U.S. dividend tax saying that "double taxation is bad for our economy...[and] wrong...[and] falls especially hard on retired people". He also argued that while "it's fair to tax a company's profits, it's not fair to double-tax by taxing the shareholder on the same profits."[2]

(Leading Warren Buffett to wonder why his income should be tax-free while his secretary pays 30%)

Soon after, Congress passed the Jobs and Growth Tax Relief Reconciliation Act of 2003, which included some of the cuts Bush requested and which he signed into law on May 28, 2003. Under the new law, dividends are taxed at a 15 percent rate for most individual taxpayers.

When the ordinary citizen needs to go to a tax preparer, the whole system is a mess, instead of targeting a particular offense against logic, we need a comprehensible system.

[Don MacAskill]

Man, I hope I'm not embarassing myself, but the tax law *is* nearly impossible to decipher...

"Employees who exercise incentive stock options pay income taxes, no matter how long they've held the options."

I don't believe that's the case. As long as you sell your ISOs 2 years after the option was granted, and 1 year after exercising, it's taxed at long-term capital gain rates (15%). Only if you have a "disqualifying disposition" (sell too early, basically), are they taxed as normal income.

Which, I believe, is the reason VC's feel they belong in that bracket. The founders and employees in the corporations in question get that treatment, so why not the VCs who are taking the risk alongside them?

(Note that I'm not arguing one way or the other, I'm just explaining what I believe in the VC mindset. I really haven't thought enough about it to know which side of the fence I'm on.)

[Maurice]

>>Of course, you can move to the UK where there is no such thing as a >>short term capital gain

Er no your wrong.

There is theres a yearly alowance for CGT around $16,000 at the moment and you get taper relief on that depending on how long you hold the stock - thers also some aproved employee stock schemes which can be very advatagous for the employees..

you also get about 14k yearly to invest in a tax free ISA which can be 100% securities (only realy helps higher rate taxpayers for incom) but you can use it to shelter securities for capital gains.

And in the UK you don't got the same problem you had in the last boom where people with worless stock options where bakrupted by tax demands - the taxman took there pensions to pay the bill I seem to rember reading.

[Henry Blodget]

Don...To get the long-term cap gains treatment with employee stock options, you have to exercise the options without selling the shares, which means putting up capital to actually buy the shares. Then, if you hold the shares for 366 days after exercising the options, you can book the gain as a capital gain.

The key point here, though, is that you actually have to put up the cash to buy the stock and then have value at risk throughout the year. It was via this "clever" tax avoiding technique that so many folks blew themselves up in 2000 (they exercised options with the stock at, say, $50 a share, then held it until it dropped to, say, $2 a share--but still owed tax on the difference between the strike and $50).

VCs do not have any capital at risk. All they have at risk are performance-based fees. This puts them in a different boat than long-term investors, who can actually lose everything.

[VC loather]

Never heard such a load of self-serving baloney. The industry will collapse? Man, these VCs sure have egos.

By-and-large, to get concessional capital gains tax rates you have to risk capital. When the VCs are prepared to personally underwrite the losses in their own funds, they can justify paying capital gains rates on the profits. Until then, they are just a bunch of greedy, self-serving crooks.

I hope Congress revokes their privilege and hits them with an additional windfall tax for being such a bunch of jerks.

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