The VC Carried-Interest Tax Debate

Today was an exciting day on Twitter. Huge debate/fight regarding the proposed "Carried Interest" tax treatment for private equity and venture capital fund managers. I mostly sat on the sidelines and retweeted the excitement (Chris Dixon told Jim Robinson IV of RRE to fuck off!). And in the middle of all this, my man Eric Wiesen, a newly appointed General Partner at RRE sent me this email…

From: Eric Wiesen
Subject:     Here's the problem
Date: June 5, 2010 9:58:21 PM ED
To:     Matt Mirele 
 
It's a problem because this tax will come in taxing carried interest, a sort of quasi-principal investing structure that GPs and LPs came up with decades ago to create the 80/20 split on the fund's upside that everyone agreed to. Post this change, LPs will be taxed at 15% which GPs are taxed at 35 or 40 or 45% (or wherever the marginal income tax rate winds up). And that will be true for current funds. But those who think this is a steady state are probably naive. Some future funds will be set up in a way that will pass some, possibly much of this tax increase onto LPs. And that lowers returns. Lower returns yield lower allocations to the asset class.
 
The alternative is actually more likely, in my view. GPs will simply come up with a different way to structure funds to simply avoid "carried interest" altogether. That's a structure that, as I said above, was merely convenient given the economics everyone wanted. Now it will be a shitty structure because despite risky, highly-uncertain returns that come many years after the original investment, GPs will be taxed as if it were "revenue". Most likely, everyone will simply get together and come up with another way to structure funds that avoids carried interest altogether. One way would be to simply say that GPs contribute "intangible assets" the way startup founders do as consideration for their founder shares. And for these intangible assets GPs will get a straight up 20% equity stake in the fund. And that will be fine for everyone (except Uncle Sam). But it's actually not as good for LPs because it's a lot harder to claw back a straight up equity ownership by GPs than it is for carried interest. 


Eric Wiesen :: General Partner, RRE Ventures

Eric is a man I know and respect. The added emphasis is mine, but the email is reprinted here with his permission. 

Now I'm not a money manager and I don't claim to be an expert on the inner workings of venture capital, but this whole argument strikes me as wrong headed…

Essentially, what the proposed law will do is recognize that money management is actually just a form of labor like any other, and tax the fees that money managers earn just like normal income as opposed to giving their management and "carry" fees capital gains treatment. Chris Dixon called this fair. VCs, acting according to their own self-interests, revolted. 

Now, back to Eric's argument: 

Future funds will be set up in a way that will pass some, possibly much of this tax increase onto LPs. And that lowers returns. Lower returns yield lower allocations to the asset class. 

Sure, SOME future funds will be setup in a way that screw LPs, but who the hell is gonna want to invest in those funds? Changing the standard fund structure across the venture capital industry will require the formation of a VC cartel. And that ain't gonna happen. Huge collective action problem. 

The reality is that VCs compete for LP money. And LPs are profit maximizers. I refuse to believe that they'll just passively accept shittier returns. I also refuse to believe that newer, younger VCs won't step up and say "Hey, I'll gladly take these management fees regardless of whether they're taxed as ordinary income or not. It's still good money!!"

More realistically, any fund manager who tries to game the system in a way that screws LPs to avoid this tax treatment better either have the last name Khosla or have very rich and very stupid friends. 

Honestly, I don't see this law affecting LPs one iota, nor do I see it diverting money from venture capital as a class. The only people I see this affecting are the VCs themselves. And really, they should pay their taxes just like everyone else. They ain't special. 

  • Jim Robinson

    Hedge funds are exactly where the debate started, then moved swiftly to include LBO shops, PE — and, at the shallow end of the PE pool — VC, as collateral damage (not my words but those of a Senator). Points I was trying to make are 1) VC – rather uniquely – participates on the left side of Schumpeter’s Curve, in the ‘value creation’ part of the program; and 2) Tax revenues generated by extending this tax to VC will be de minimis… but the damage could be substantial. Perhaps I overestimate it (let’s hope so), but I am certain it will not be zero.
    Most in Congress are aware of the VC ‘issue’ at this point, but simply do not want to get bogged down in ad nauseum debates around ‘what is a VC firm’ (and the game theorists that will have a field day squeezing into new definitions). I certainly understand their reluctance, but worry the instinct to ignore it will genuinely hurt our startup ecosystem. And sure, there is self-interest on my part, but if that were the only thing, I wouldn’t bother.

  • Jim Robinson

    Hedge funds are exactly where the debate started, then moved swiftly to include LBO shops, PE — and, at the shallow end of the PE pool — VC, as collateral damage (not my words but those of a Senator). Points I was trying to make are 1) VC – rather uniquely – participates on the left side of Schumpeter’s Curve, in the ‘value creation’ part of the program; and 2) Tax revenues generated by extending this tax to VC will be de minimis… but the damage could be substantial. Perhaps I overestimate it (let’s hope so), but I am certain it will not be zero.
    Most in Congress are aware of the VC ‘issue’ at this point, but simply do not want to get bogged down in ad nauseum debates around ‘what is a VC firm’ (and the game theorists that will have a field day squeezing into new definitions). I certainly understand their reluctance, but worry the instinct to ignore it will genuinely hurt our startup ecosystem. And sure, there is self-interest on my part, but if that were the only thing, I wouldn’t bother.

  • Smaller fund structures going a long way towards mitigating this problem and aligning interests.

  • Smaller fund structures going a long way towards mitigating this problem and aligning interests.

  • Hey matt, totally agree. I did not mean to imply that you are out of line at all. More of general comment in response to the uber heated dialog occurring across the blogsphere. Sorry abt that!
    I’m all for reasonable and respectful debate.
    -b

  • Hey matt, totally agree. I did not mean to imply that you are out of line at all. More of general comment in response to the uber heated dialog occurring across the blogsphere. Sorry abt that!
    I’m all for reasonable and respectful debate.
    -b

  • That clears up everything totally. Thanks.

  • That clears up everything totally. Thanks.

  • Adam

    Fees received for actively managing assets (ie. management fees) are taxed as ordinary income, the appreciation of those assets, since the manager is passive in the appreciation/gain of those assets (ie. portfolio companies) the appreciation is taxed as a capital gain. GP’s get a share of that appreciation alongside LPs and are taxed similarly. Note the difference active vs. Passive.

  • Adam

    Fees received for actively managing assets (ie. management fees) are taxed as ordinary income, the appreciation of those assets, since the manager is passive in the appreciation/gain of those assets (ie. portfolio companies) the appreciation is taxed as a capital gain. GP’s get a share of that appreciation alongside LPs and are taxed similarly. Note the difference active vs. Passive.

  • I don’t believe the ‘fraud’ in venture capital is the carried interest structure and taxes, i believe its the management fee. Most funds state 2% though the actual is much higher due to the fact things like accounting and legal fees are billed separately to the partnership. Im a believer that under no circumstance should a VC get rich if their LP’s aren’t getting richer and this is happening out there. We need to be doing more to align the interest of the GP and LP.
    Part of me wonder’s if VC is just getting caught in the cross fire of hedge funds which have been under plenty of scrutiny over the years.
    Should the gov’t be implementing any actions that could impact job creation and growth in the economy? Only time will tell if this change negatively impacts the venture ecosystem and if it does it probably will be looked at as a short sighted mistake.
    As an aside my accountant has written a paper on why this isnt really accomplishing what the gov’t wants, its very technical and im trying to get him to make it an easier read, if he does ill send it along.

  • I don’t believe the ‘fraud’ in venture capital is the carried interest structure and taxes, i believe its the management fee. Most funds state 2% though the actual is much higher due to the fact things like accounting and legal fees are billed separately to the partnership. Im a believer that under no circumstance should a VC get rich if their LP’s aren’t getting richer and this is happening out there. We need to be doing more to align the interest of the GP and LP.
    Part of me wonder’s if VC is just getting caught in the cross fire of hedge funds which have been under plenty of scrutiny over the years.
    Should the gov’t be implementing any actions that could impact job creation and growth in the economy? Only time will tell if this change negatively impacts the venture ecosystem and if it does it probably will be looked at as a short sighted mistake.
    As an aside my accountant has written a paper on why this isnt really accomplishing what the gov’t wants, its very technical and im trying to get him to make it an easier read, if he does ill send it along.

  • Hmm. Ok, so the 2% management fee is already taxed as ordinary income, didn’t know that…might be helpful if you blogged about the subject, as it is a bit nuanced and confusing for us entrepreneurs.
    Also, i think its worth pointing out that I’m––quite atypically––one of the more reasonable and civil parties to this debate.

  • Hmm. Ok, so the 2% management fee is already taxed as ordinary income, didn’t know that…might be helpful if you blogged about the subject, as it is a bit nuanced and confusing for us entrepreneurs.
    Also, i think its worth pointing out that I’m––quite atypically––one of the more reasonable and civil parties to this debate.

  • Ha! Hardly a swipe at Vinod Khosla. The spelling error was mine. I meant to imply that LPs should and would continue to throw money at the man regardless of whether he setup an exotic fund structure or not.

  • Ha! Hardly a swipe at Vinod Khosla. The spelling error was mine. I meant to imply that LPs should and would continue to throw money at the man regardless of whether he setup an exotic fund structure or not.

  • First, mgmt fees are approprietly taxed as ordinary income, not capital gains. Might want to fix that in the post.
    Second, we’ve got to avoid oversimplifying this debate. On the one hand, carried interest is like ‘fee’ income because it is generated off of the risk capital of others. On the other hand, carried interest (in venture capital, at least) is a highly volatile, risky, unpredictable and long dated derived from making real value creating investments – from this perspective it feels more like long term capital gain-type income. And of course, there are always capital redistributing effects (to varying degrees of impact) of any change in tax policy.
    As I’ve repeated 10 times today (which is unfortunately driven by the unnecessarily polarizing positioning of this debate), I’m supportive of the tax increase on carried interest. At the end of the day, i believe the redistribution impact will be minimal and don’t believe capital gains treatment should apply to investing other peoples risk capital.
    But it is neither crazy nor necessarily greedy to argue the other side of this debate.
    Reasonable people can disagree. Let’s just keep the dialog respectful.

  • First, mgmt fees are approprietly taxed as ordinary income, not capital gains. Might want to fix that in the post.
    Second, we’ve got to avoid oversimplifying this debate. On the one hand, carried interest is like ‘fee’ income because it is generated off of the risk capital of others. On the other hand, carried interest (in venture capital, at least) is a highly volatile, risky, unpredictable and long dated derived from making real value creating investments – from this perspective it feels more like long term capital gain-type income. And of course, there are always capital redistributing effects (to varying degrees of impact) of any change in tax policy.
    As I’ve repeated 10 times today (which is unfortunately driven by the unnecessarily polarizing positioning of this debate), I’m supportive of the tax increase on carried interest. At the end of the day, i believe the redistribution impact will be minimal and don’t believe capital gains treatment should apply to investing other peoples risk capital.
    But it is neither crazy nor necessarily greedy to argue the other side of this debate.
    Reasonable people can disagree. Let’s just keep the dialog respectful.

  • Hey Matt, well argued.
    Time will tell how things will exactly shape up, but it is quite safe to say that LPs will continue to invest in trustworthy and competent fund managers. As a corollary, it follows that LPs will avoid managers who create complicated structures just to work around the carried interest tax.
    Your rebuttal actually also applies equally well to another argument that’s making rounds: That the fund managers will now try to pass on this tax to the entrepreneurs somehow. High quality entrepreneurs would rather go with good VCs than with those who try to tax them 🙂
    Just one thing: I didn’t get the swipe at ‘last name Khoshla’. If the spell error is deliberate, then I’d like to know whether you have any specific data to support that swipe. I have a high regard for the man. You can DM me @vsagarv or email me [in total confidence] at .

  • Hey Matt, well argued.
    Time will tell how things will exactly shape up, but it is quite safe to say that LPs will continue to invest in trustworthy and competent fund managers. As a corollary, it follows that LPs will avoid managers who create complicated structures just to work around the carried interest tax.
    Your rebuttal actually also applies equally well to another argument that’s making rounds: That the fund managers will now try to pass on this tax to the entrepreneurs somehow. High quality entrepreneurs would rather go with good VCs than with those who try to tax them 🙂
    Just one thing: I didn’t get the swipe at ‘last name Khoshla’. If the spell error is deliberate, then I’d like to know whether you have any specific data to support that swipe. I have a high regard for the man. You can DM me @vsagarv or email me [in total confidence] at .

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