Carried Interest Bill Arrives

Note: I’ve decided to move this post back up top for the next day or two — since the issue has struck a nerve among peHUB readers.

Several Democratic congressmen have introduced legislation that would change the tax treatment of carried interest — from capital gains to ordinary income. It would apply to all “investment management firms” — which would include venture capital funds, mezzanine funds, growth equity funds buyout funds, hedge funds and real estate funds.

You can download the bill here:
Investment Mgmt Services Signed.pdf

Here is a fact sheet — FactSheet.doc – provided by bill sponsor Rep. Sander Levin (D-MI).

Levin said the following, in a prepared statement: “Investment fund employees should not pay a lower rate of tax on their compensation for services than other Americans. These investment managers are being paid to provide a service to their limited partners and fairness requires they be taxed at the rates applicable to service income just as any other American worker.”

Levin also was just interviewed on CNBC.

The National Venture Capital Association has just issued the following statement:

“The Bill proposed today by House Democrats to change the taxation of carried interest from a capital gains rate to an ordinary income rate is extremely concerning to the venture capital community. We assert that carried interest in the venture capital business model is a true capital gain and should continue to be taxed at that appropriate level. This proposed legislation could have far reaching, negative implications for the start-up community, venture capital investment, and the US economy. It is critical that legislators identify and fully comprehend the unintended consequences of this proposal as it could impact one of the country’s most important economic engines. We look forward to continuing a dialogue with members of Congress on this issue as the legislative process continues.”

Related Posts

145 Comments

  • This SUCKS! Not only has Congress managed to help create a “brain-drain” in this country by making visa requirements so difficult and also cripple our liquidity markets as a result of SARBOX, but now they want to try and stifle one of the greatest vehicles for creating growth and innovation in this country (VC/PE). This is sad.

  • Do you think corporate CEO’s would accept lucrative pay packages only after they generate an 8% compounded annual return for shareholders?

  • But, I suppose their salaries are no longer tax exempt?

  • Why should I download this and poison my computer?

  • Thanks to all of the Blackstone m(b)illionaires who caused the Levin bill to be created. I spend 6 six years working on VC investments during a period in which the top quartile of fund return the money. Hoping I will see a carried interest dollar in a few years, now I can look forward to paying double on the taxes. Didn’t I take a salary cut for the risky upside? Note to Rep. Levin, I will never buy a car froma Michigan-doimiciled auto maker.

  • Those dems are smart and right

  • its about time

  • Carry is generally not ordinary income. It’s a partnership distribuition that reflects the investment manager’s of the capital gain from selling a company.

  • This legislation makes total sense. Carried interest is compensation for services. If you want to argue that it’s capital gain, then shouldn’t investment bankers who earn a percentage of a deal’s value as their fee treat that as a capital gain too? Where would it all end? There is a legitimate discussion about what ordinary income tax rates should be, there is no legitimate argument that this is not ordinary income. Capital gains relate to capital risks, not to time spent or effort or skill applied.

  • Envy. If the congressman were interested in fairness, and in a tax structure that would benefit business and working people alike (and getting Congress out of the loophole and campaign contribution business), he would be endorsing the “Fair Tax.” http://www.fairtax.org

  • Rob said:

    Carried interest is compensation for services.

    No it isn’t. It’s capital gains passed out to one of the partners. Let’s say I run a partnership. That partnership buys an asset at $10 which it later sells for $20. Most of us would recognize that as a capital gain.

    Now, when the partnership distributes the $20, by pre-agreed arrangement I get a little more of the gain allocated to me.

    A partnership is a pass-thru entity. It simply passes the features of the underlying transaction up to the partners. If the underlying share of the profit was a capital gain, my share of the profit is also a capital gain.

  • I don’t want to get into a debate with diz. But that “pre-agreed arrangement” involves one party providing services to the others, it just happens that they have agreed to structure the compensation in a way that is mathematically expressed as a % of the upside. But there is no downside so no capital loss is possible. I don’t think anyone would argue that this was capital gain if capital gains rates were higher than ordinary income rates. Do you?

  • Rob said:

    that “pre-agreed arrangement” involves one party providing services to the others

    For their services, they get allocated a bigger share of the partnership’s capital gains.

    When an entity buys something for $10 and sells it for $20, that’s a $10 capital gain, right?

    Regardless of whether I allocate that $10 gain ($8 to you and $2 to me) or ($7 to you and $3 to me), it was still a $10 capital gain.

    The IRS should not be entitled to more of that gain because of how it is allocated.

  • Diz agrumentation is legally correct, but the question Congress faces is not of this is legal but the fairness of the current law towards other Americans.

    It should be possible to calculate the fair market value of the carried interest at the beginning of the partnership (can’t be that much since it’s a highly risky and volatile investment), if at the end the carry is worth more than the initial fair market value then nobody can claim it’s not a genuine capital gain.

  • Diz said: “Regardless of whether I allocate that $10 gain, it was still a $10 capital gain.”

    Not entirely correct, the manager has delivered services to the partnership and didn’t charge the partnership the fair market value for those services (if they did there was no need for a carried interest), the result is that the profit of the partnership is artificially increased.

  • Isn’t the norm “Substance over form” – when looking at carried interest we should look at the substance of the transaction and not the form. Carried interest is capital gain becuase you first have to purchase an asset and then sell it – you only get carried interest if there is a gain. The reason why investment bankers cannot treat fees as capital gain is because the DO NOT own asset when they advise their client.

    Also, just because there is no downside (althoug I think there is) does not mean that this is not a capital gain. You have to think of carried interest like an option – where the downside is sort of “hedged” – now when you buy an option and it gains in value you will not treat this as income.

  • Anyone who thinks that this is income and not capital gains is ignorant to the mechanics of a private equity partnership.

    –If I am required to invest $500,000 of my own money alongside the LP’s, why is that different from $500,000 invested in Apple stock? In fact, most private equity professionals are expected to put a significant percentage of net worth at risk for each fund.

    –There IS downside. I may never see that $500,000, if the fund does achieve the returns.

    –The risk of the security is higher (and therefore the return), becuase it does not participate until certain return thresholds are met.

    –The difference between an investment banker’s bonus and PE carry is that the PE professionals HAVE CAPITAL AT RISK TO EARN THAT CARRY. IBers do not.

  • If they really wanted to tax this appropriately the IRS should tax carried interest at the time of capital calls and then have it be subject to capital gains on distributions. Carry is really the LP paying the GP’s share of an investment and should be viewed as income at that time.

    This is even worse for Private Equity so count your blessings.

  • FYI, Here’s a statement just released from the National Venture Capital Association:

    NATIONAL VENTURE CAPITAL ASSOCIATION STATEMENT ON
    CARRIED INTEREST BILL

    Washington D.C, June 22, 2007 — The following statement is attributable to Mark Heesen, president of the National Venture Capital Association (NVCA) in response to today’s introduction of legislation by House of Representative members Sander Levin (D-MI), Charles Rangel (D-NY) and Barney Frank (D-MA):

    “The Bill proposed today by House Democrats to change the taxation of carried interest from a capital gains rate to an ordinary income rate is extremely concerning to the venture capital community. We assert that carried interest in the venture capital business model is a true capital gain and should continue to be taxed at that appropriate level.
    This proposed legislation could have far reaching, negative implications for the start-up community, venture capital investment, and the US economy. It is critical that legislators identify and fully comprehend the unintended consequences of this proposal as it could impact one of the country’s most important economic engines. We look forward to continuing a dialogue with members of Congress on this issue as the legislative process continues.”

    The National Venture Capital Association (NVCA) represents approximately 480 venture capital and private equity firms. NVCA’s mission is to foster greater understanding of the importance of venture capital to the U.S. economy, and support entrepreneurial activity and innovation. According to a 2006 Global Insight study, venture-backed companies accounted for 10.4 million jobs and $2.3 trillion in revenue in the United States in 2006. The NVCA represents the public policy interests of the venture capital community, strives to maintain high professional standards, provides reliable industry data, sponsors professional development, and facilitates interaction among its members. For more information about the NVCA, please visit http://www.nvca.org.

  • What I find troubling here is the long term impact on the venture market. As noted in the NVCA comment, the negative impacts on the investing market will ultimately hurt our innovative competitiveness on a global level. The effect of a tax on a market is equilibrium is an artificial price increase, resulting in lower demand. Lower demand leads to less investment activity, which would later lead to fewer jobs created by new companies.

    Venture-backed firms created 600,000 jobs nationwide from January 2001 through December 2003, according to a study by Global Insight, a private economic firm hired by the National Venture Capital Association. That was a net gain of 6.5 percent in jobs for venture-backed companies, which account for nearly 10 percent of all private jobs. Revenue among venture-backed companies grew by $212 billion, or 11.6 percent, during the same period.

    Has anyone read Milton Freidman’s “The World is Flat”? We are already losing enough ground in the global marketplace, why would we worsen our position?

  • Sorry for the typo, I meant “The effect of a tax on a markets equilibrium is an artificial price increase”

  • Simply tax the GP’s portion of assets at risk, those that they have invested alongside the LP’s, as capital gain upon any sale, and tax the GP’s 20% performance fee on any LP’s gain as income. That’s not difficult to sort out. It would be the same if you were trading a bank’s book and received an annual bonus on your trading profits. It would be taxed as income not capital gains.

    Peace

  • As the only Democrat I know wholly supportive of a flat tax on any type of income above the poverty line, this is just great fodder for my cannon! By manipulating the tax code to the benefit/detriment of one party’s supporters or the other, we’re making the business climate uncertain, and there’s nothing worse for investors than uncertainty. This sort of politically driven tax-babble may have a dampening effect on the pace at which innovations reach the market. In a time of global competition, as you’ve mentioned in other columns vis a vis the same issue in Great Britain, there’s little preventing the capital from leaving the US and going somewhere more advantageous.

    I’m a card carrying lefty, and even I think a flat tax is the only way.

  • [...] In less than 12 hours, Schwarzman has gone from prince to piñata. Why the rapid fall from grace? Because people blame Schwarzman and Blackstone for the carried interest legislation that could raise taxes from the capital gains rate of 15% to the ordinary income rate of around 35 percent. I’ve gotten a couple dozen emails saying something of the sort, and have seen it bandied about the blogosphere. So now to the important question: Is Blackstone to blame? [...]

  • Jeffrey and Brian are correct to be looking at this in the context of the larger tax and economic issue, and getting out of the weeds of our 40,000 page existing tax code. We could argue all day about whether carried interest is more like service income or more like allocation of gain (and Congress will). This is why we spend so many billions of dollars each year just figuring out how much we owe in taxes. It’s counterproductive, unless you’re a congressman buying votes or scoring cheap points against “the rich” VCs, or other wealth creators (OK, VCs can also make small fortunes by starting with big ones). What we need for a growth economy, the return of vast sums of capital to the US, and the retreat of government from our private lives is an efficient, predictable, easily complied-with, fair tax system that requires no individual returns, eliminates income tax, estate tax, payroll tax, social security and medicare tax withholding and the returns that go along with them, and that’s a national retail consumption (sales) tax (with “pre-bate” for poverty-level spending). http://www.fairtax.org (there are now 62 sponsors for this in the House)

  • If I’m a GP who has invested and taken risk in the investment alongside my investors, this proposal is ludicrous. If I simply manage a fund and have taken no risk and my income is extraordinarily high, then it seems fair. Many hedge fund managers are making $100′s MM yr and should pay ordinary income taxes, not capital gains. It’s about time, the super rich guys start paying more taxes.

  • Give me a break…the PE/VC guys have been making a mint for years. Now they have to pay on a carried interest which is, at the end of the day, a performance based bonus since only the part not related to an investment on their part (they are LPs with real risk at that point) is include in the ordinary tax proposal at hand. Everyone else who gets paid for how well they create value in the form of a perfomrance-based bonus/commission has to pay ordinary income why do PE/VC professionals believe they should be treated differently? How many people actually believe that a whole bunch of PE/VC professionals are going to abandon the industry over this? They still make money on other people’s money without risking their own (unless they are LPs). I used to be a VC and can tell you with total confidence that all this complaining is hypocritical, they know they have had a sweet deal for a long time. Further, today PE/VC are like bankers, risk talking is just marketing, they want (and mostly only invest in) sure deals with minimal risk. All this talk about aligning incentives is self-serving justification…[and the PE/VC professionals know this too]. BTW, American growth will only be effected if the high-growth opportunities (i.e. portfolio companies, etc.) move overseas. The money (i.e. the LPs) still get taxed as capital appreciation…believe me, THEY will find a way to deploy this capital where the growth is.

  • Let’s say I start a business by borrowing $100,000 from my mom and I own the company. If I sell the business for $200,000, I pay off the loan and keep the rest. Capital gain, right? Now suppose my mom doesn’t have the money, but I get a bank to loan me the money. Only they want me to pay interest and give them 10% of the company because it’s a risky investment. I sell the company, pay off the loan, and give the bank it’s 10%. My 90% is capital gain, right? Now suppose I can’t get a loan at all, but I sell an 80% interest in my company to institutional investors and keep 20% of the ownership after paying off the investors preferred equity. My 20% is no different than the 90% or the 100%. But if I call it carried interest and I’m wildly successful then Sander Levin and Max Baucus and many others decide to target a certain group of successful taxpayers on the basis of a fairness argument. If Washington wants to raise more money from capital gains, raise the rate on everyone. Not just guys named Steve, or Henry, or David, or Leon who happen to be extremely good at what they do.

  • Everyone jumped on this bandwagon so quickly because no capital was “at risk” and that it’s not on parity with tax treatment for other types of economic activity. As a benefit at different types of both stock options and carry at different times in my career, there is at least one big salient reason why that litmus test fails.

    What about the capital gains on long term stock options at venture and private equity backed startups? Or the stock options for employees at public companies?

    There is no employee capital at risk but they still get long term capital gains treatment, just as those with carried interest do.
    Employees get salary and carry just like investment professionals do, and salary is usually is much smaller relative to carried interest. Just like people with carry.

    How many instances of a CEO have you seen get exorbitant pay from vest stock options. Why should they continue to get capital gains treatment with no capital at risk while their investors pay the same type of gain on the same security at rates twice as high?
    If Congress is on a money hunting expedition as our budget is about to go into deficit, they better get it done since a big traunch of Google options are about to vest. Since all those employees funded the company originally and put their own money in to buy all their shares. Just like Sergei did eh?

    Should employees at private equity funded companies get a more favorable tax code then those managing the investment/? That’s right, we shouldn’t.

    What’s the truth here? There is only fact I know 100% for certain. The tax code is a mess and Congress is the last institution that could ever engineer a fair one. The sooner we move to consumption based taxes–here people are taxed on big yacht purchases or lavish birthday parties vs. trying to social engineer through the tax code the better off we will all be. Get the big spenders where you can get them for real, where they spend.

  • Employee stock options are no different. Are we going to remove beneficial treatment for those as well as every other comparable activity?

    Our tax code is a hodge-podge of different rates and exemptions based on incentivizing or discouraging different types of economic activity based on the fluctuating influence of various special influence groups from year to year.

    Everyone jumped on this bandwagon like lemmings marching to a cliff based on the notion that no capital was “at risk” and that it’s not on parity with tax treatment for other types of economic activity. Lots of things don’t have parity in the tax code. As a beneficiary at different types of both stock options and carry at different times in my career, there is at least one big salient reason why that litmus test fails.
    Do people not realize capital gains on long term stock options at venture and private equity backed startups are taxed at 15%? Or the stock options for employees at public companies? Same thing. They are capital gains even though no capital is at risk.
    • There is no employee capital at risk but they still get long term capital gains treatment, just as those with carried interest do.
    • Employees get salary and carry just like investment professionals do, and salary is usually is much smaller relative to carried interest. Just like people with carry.
    • How many instances of a CEO have you seen get exorbitant pay from vest stock options. Why should they continue to get capital gains treatment with no capital at risk while their investors pay the same type of gain on the same security at rates twice as high?
    • If Congress is on a money hunting expedition as our budget is about to go into deficit, they better get it done since a big traunch of Google options are about to vest. Since all those employees funded the company originally and put their own money in to buy all their shares. Just like Sergei did eh?
    Should employees at private equity funded companies get a more favorable tax code then those managing the investment/? That’s right, we shouldn’t. What’s the truth here? There is only fact I know 100% for certain. The tax code is a mess and Congress is the last institution that could ever engineer a fair one with its annual tinkering exercise. The sooner we move to consumption based taxes–here people are taxed on big yacht purchases or lavish birthday parties vs. trying to social engineer through the tax code the better off we will all be. Get the big spenders where you can get them for real, where they spend.

  • Carried interest is capital gains pure and simple. If there is no capital gain there is no carried interest.

    Think of it this way, an LP commits $10M and the GP turns it into $30M. Everyone agrees there is $20M capital gains here, yes?? Hard to say there isn’t. Thus the tax due is $3M (assume 15% rate)

    Now explain to me why, just because the LP has agreed to give 20% of this gain to the GP, the characteristic of this gain has changed into ordinary income and now the total tax due is $3.8M (15% on $16M and 35% on $4M)

    The argument that the GP does not have anything at risk is missing the point (at best), the reality is that there is $20M of capital gains.

    People are getting hung up on the concept that the GP has nothing at risk, this is irrelevant since the LP DID risk capital, which resulted in a CAPITAL GAIN. No one can argue that this is not true. The real issue to argue is whether someone (an LP) can legally transfer capital gain to another person (the GP).

    If the code is changed the lawyers will find a way around it via a new derivative instrument between the LPs and the GP outside of the Fund waterfall calculations. For example, as a GP, I will buy an option from each LP directly for 20% of their profits and I will pay them some nominal amount, maybe $1.00 each. I now have basis of $1.00 and anything in excess will be capital gains, just like a regular stock option, assuming my hold period is more than one year.

    How would you feel if you managed your wealthy fathers’ money and he agreed to give you 20% of the profits for doing this. Then you generate $20M in capital gains, why should the IRS get more than 15% of the total capital gains? I would think most people would argue for capital gain treatment.

    Get over it people or if you are going to change this compensation method you better change the taxation on stock options as well.

  • I don’t know how many times I’ve said this, but I’ll chime in again for the cause. I’ll stay out of the politics because I really want to emphasize the point that this is what makes the most sense.

    The way to look at this is to look at where the money is coming from. Management fees are a payment made directly from LP’s to GP’s – ordinary income. Carried interest is derived from capital gains made on the principal that has been provided by LP’s on behalf of the GP. Essentially, the government should be charging ordinary taxes on the notional principal amount upon which the total amount is gained, and capital gains taxes on the remainder.

  • What on earth is wrong with me? Worst typos of 2007!

    I don’t know how many times I’ve said this, but I’ll chime in again for the cause. I’ll stay out of the politics because I really want to emphasize the point that this is what makes the most sense.

    The way to look at this is to look at where the money is coming from. Management fees are a payment made directly from LP’s to GP’s – ordinary income. Carried interest is derived from capital gains made on the principal that has been provided by LP’s on behalf of the GP. Essentially, the government should be charging ordinary income taxes on the notional principal amount upon which the total amount is based, and capital gains taxes on the remainder.

  • We all like to make lots of money, and not pay taxes, but in my view, the proposed legislation is only fair. Carried interest is indeed an income for PE professionals, not related to any capital invested by them. Capital gain is by any definition an increase of capital invested and Carried Interested is not. I enjoy reading people’s arguments on how and why CI is not a regular income, but it pretty much reminds me of Bill Clinton saying “define sex!”

  • The idea of a huge liability has gotten lost in this carried interest debate, specifically to outsiders looking in. The
    idea that you have a future obligation as heavy as the returns you are getting does not seem to be a strong argument especially when
    everything works great and no one goes under. But, last week, Bear
    Sterns lived up to an obligation by infusing 3.2 billion in two
    sub-prime hedge funds they were running. I think if someone could
    connect this fact (that private money was helping the American dream
    move along for those American’s with very poor credit ratings) with
    the heavy future obligation which creates the carried interest as an
    economic incentive, well then, we may look better to those outsiders
    looking in.

  • Tax policy is being discussed as if it was discovered on a stone tablet centuries ago and has remained unchanged. Tax policy has always been used to promote public policy such as saving, investment and farming. The treatment of carried interest is no different and this is not simply a debate about capital gains v ordinary income. Venture Capital has done great things for the country over the last 40 years and it has done so by attracting some of the best minds in the world who are willing to take big risks. Tinker with the tax treatment that has been used over that period and things will change – that is simple cause and effect. If the elected officials are unhappy with the industry that has brought the U.S. Intel, Amgen, Apple, Genentech, Google and hundreds of thousands of jobs, then tinker away but do not do so lightly.

  • Walter,
    Do you really believe that a tax increase would cause VCs to quit their jobs? For what? Non-investing jobs where they also will be taxed as ordinary income?

    I get your overall point, but I think Congress is betting that VCs will complain, then suck it up and get back to work (and maybe raise carry percentages a bit)…

  • One more point that I have made previously, but I will fill it out a bit this time with an example.

    I would suggest that a clever tax guy could always find ways around the new tax law to accomplish the same thing.

    Here is one (not very well thought out – — right off the top of my head so it may have lots of problems) example.

    Old structure (gross generalization)

    Limited Partnership Structure: receiving 100% of funds ($100 raised)

    Contributions:
    LP 99%
    GP 1%

    Profits:
    LP 80%
    GP 20%

    New Structure

    Limited Partnership

    Limited Partnership Structure: receiving 5% of funds
    LP 80%
    GP 20%

    Loan To Partnership: 95% of money raised
    LP: 100%

    It would take a little more time to come up with an interest rate/subordination/covenants that would effectively provide essentially the same deal as existing partnerships, but I suspect it could be done.

    Its all a question of form over substance.

  • I agree with you Dan. I think this is a great bill — at least as long as our goal is driving every profitable firm out of the US.

    First, it was just public PE funds. Then, all alternative investments. I have a good idea for what to do next. Why don’t we force companies to pay the corporate tax rate on each of its lines of business (ie Gap, Old Navy, Banana Repub.), then tax the parent company (Gap) at the corporate rate, then tax shareholders and see who stays around? because isn’t that what we’re already planning for PE firms?

    Perhaps congress should realize that helping US companies grow/make money is actually a good thing.

    Does the press get a fee for advising the government on this?

  • My data says of the 343 US Venture Funds raised since 1999, only 7 are cash on cash in the black, and those not by much. So with respect to taxing VC carry as compensation, there simply is no `there` there in terms of material revenues for the Treasury. I can tell you starting companies as a principal rather than an agent is a viable alternative for most of the best VC`s – and one many will pursue if hard earned carry (decades for people who started in the mid our late 90`s) is taxed at high rates. For those who create real value and national wealth, taxes have always been more or less voluntary – you can always play Atlas Shrugged. A lot of VC`s will do just that. As public policy, this is just self destructive to the country and its technological hegemony over the rest of the world. Its just dumb.

    And will KP and Seqioua keep making money for MIT and Stanford if it means 40% percent taxes? (a big piece of he 7 in the black firms above) They will be their own LP`s, and keep paying 15% — at the expense of the charities they work for today.

  • jack,
    i spoke today w/ the congressman who introduced the bill. he says it’s all about tax equality — not about raising fed revenue. but, leaving that aside for a moment: your stats make me think that the VC industry has a far bigger problem than Congress. It is no longer profitable — taxes or no taxes.

  • War On ‘Rich’ Has Claimed First Casualties
    By LAWRENCE KUDLOW | Posted Tuesday, June 26, 2007 4:30 PM PT

    Last Friday’s precipitous stock market plunge, with the Dow industrials dropping 185 points, is all about Washington’s continued war on prosperity. The latest assault comes courtesy of House Democrat Sander Levin.

    Late last week, he introduced a bill that essentially would abolish the 15% capital-gains tax preference for risk investing, and raise it by 20 percentage points to the 35% corporate and personal rate.

    This goes beyond an earlier tax attack on a public offering by the Blackstone Group, and would slam into all private partnerships, including buyout funds, hedge funds, venture-capital firms, real estate partnerships and oil-and-gas deals.

    Incidentally, while attacking capital gains, the congressional Democrats are killing initiatives for across-the-board cuts on wasteful appropriation bills. According to the Club for Growth, House Democrats defeated separate measures that would cut spending by 4%, 1% and 0.5%.

    Does this mean the Dems favor tax hikes over real spending control? It appears so.

    Washington economist Kevin Hassett says this is part of the Democrats’ “war against winners,” and he’s right on the money. In particular, these willy-nilly changes of the tax rules would have a chilling effect on capital formation, and could constitute the biggest attack on capital since the 1930s.

    As mentioned, the lightning rod in this tax-hike endeavor was the Blackstone Group, the private-equity giant that went public last week. Blackstone’s investment-fund profits are taxed at the 15% cap-gains rate, and since these profits come from high-risk investments, that’s how it should be. But Democrats in Congress view these profits as plain income, and greedily want a higher take.

    But plain ol’ income this is not. The recent crack up of two Bear Stearns sub-prime-mortgage hedge funds shows just how risky these ventures can be.

    Yes, there’s big money to be made when these private partnerships click. But the economy-at-large also is a beneficiary. Private buyout funds often save highly troubled companies from bankruptcy. They insert skilled managers who streamline operations and make businesses more efficient, a process that can ultimately lead to greater profits and business expansion.

    You know a lot of these companies: Chrysler, Staples, Sears, Domino’s, Dunkin’ Donuts, Toys “R” Us, Clear Channel Communications, Hospital Corporation of America. All of these firms were brought back from the dead, thanks to private partnerships.

    Nobody knows for sure whether Congress will green-light the Democrats’ anti-growth agenda. The hope is that President Bush will veto any tax hike that lands on his desk. But the mere threat that Congress would embark on such a program of wealth destruction and economic impoverishment — all in the name of taxing “rich people” — has investors reeling.

    Ironically, a lot of today’s anti-cap-gains momentum is the handiwork of former Clinton Treasury Secretary Robert Rubin. He actually believes a low cap-gains tax has no economic growth impact at all.

    However, back when Clinton and Rubin were running things, the personal income-tax rate was lifted from 31% to 40%, while the cap-gains tax was reduced from 28% to 20%, making for a 20 percentage-point tax advantage for cap-gains over regular income. Flashing forward, the current Bush administration lowered the income-tax rate to 35% and the cap-gains rate to 15%, preserving that 20% differential.

    Hmm . . . Is Rubin saying the cap-gains tax advantage was good for the Clinton boom, but not the Bush boom?

    Truth is, that differential provides a strong incentive for entrepreneurial risk-taking and higher-risk, cutting-edge investment — both of which lend torque to the economy.

    Another unfortunate irony is that while Democrats think they’re striking out at the rich, they’re actually jeopardizing the retirement portfolios of millions of middle-income Americans.

    Firemen, police officers and teachers, to name a few, are all represented by the big state and city pension funds. And these funds are heavily invested in the hedge and private-equity funds that the Democratic tax machine is targeting.

    Is this fact lost on the Democrats? And don’t they realize that two out of every three voters in recent elections owned stocks — either directly or indirectly? Are they attempting to commit political suicide?

    If the Democrats get their way, job creation will be affected, too. Clearly you can’t create new jobs in the private sector unless there’s a new or expanding business to create those jobs. And since new and expanding businesses require capital for investment funding, if you tax that capital more, you get less investment and fewer jobs.

    You can’t have capitalism without capital. The process works for “rich people” and the middle class. When Democrats wage war against the rich, the middle class becomes the collateral damage. This may be the law of unintended consequences, but it’s something this Congress fails to understand.

    Copyright 2007 Creators Syndicate, Inc

  • If this absurd bill becomes law, will existing VC and LBO partnerships, established under the “old” rules, become subject to the “new rules.” A retrospective tax is even more confiscatory than a prospective one.

  • “Complain, suck it up and get back to work”, huh? Don’t kid yourself. If we wanted to bend over and be good little socialists, we would probably find another line of business. Clearly, those of you in favor of this tax treatment really don’t get the mechanics (or how subordinated in terms of timing it can be) of carried interest. Just for the record carried interest is not a foregone conclusion or how much it will be. Does that sound like income?

    So LPs should pay cap gains (or not at all) on realized investments and GPs should pay as income. Okay, I’m thinking in-kind distribution of securities instead of cash.

  • Dan: You are right about Founders equity as it pertains to the Google founders I brought up in my example. But I am not so sure you are right about options at startups. At least in all scenarios. They have no notional value so I am not sure an ordinary income trigger occurs. Maybe a tax guy can chime in who has seen a lot of this. I think it also depends on if the options are nonqualified or qualified. It’s been a while and all I remember is -it’s complicated. Also if the options are 5% of the current price because of appreciation, it seems a distinction without a difference. However, it sounds like you at least agree founders equity is a double standard, so are you advocating founders equity now be taxed as income? That would be a new one for the United States.

  • All this talk about fairness on the part of the politicians is just plain baloney. This bill is patently unfair in that it targets a select group of professionals for punishments while conveniently leaving others untouched (I won’t repeat the arguments here about founders stock).

    A couple of points I wanted to make:
    First to Dan Primack: To think that this bill will have no consequences for the industry and everything will be the same “because VCs will just suck it up and go back to work” is naive at best. There are obvious ways that this may affect the industry, like GPs leaving and starting companies on their own or money moving overseas, but also subbtle ways, like fund size increasing thereby leaving a bigger vacuum at the early stage. If there is one thing for sure is that many of the consequenses will be unanticipated and unintended. It’s even sillier to claim that b/c avg. returns in the VC industry have suffered it doesn’t matter that carry is being punished. If you really think that this is not a driver of innovation in the economy you should just start covering buyouts.

    Second:
    It is not credible to claim that the GP has nothing at risk when managing funds. Did we forget the times when a GP earlier in this decade actually lost money out of his pocket for being locked up in a stock distribution that then went south and LPs had to be made whole or where taxes were due and the LPs had to be made whole?

  • I wouldn’t be supprised if this proposed tax change, if approved, only had a limited effect. The PE industry had some of the most talented legal minds working for it. They will create a legal falicy to modify the investment nature of its carried interest.

    How about just making the carried interest a return on the GP’s co-investmnet obligation. The LP’s of a high performing fund will be more than happy to modify their legal documents to keep their investmnet managers happy.

  • Won’t funds be able to get around a new bill like this simply by changing the structure of the funds? For instance, rather than “managing” the capital of institutional LP’s, the GP’s can “borrow” the money and pay the LP’s back at a variable rate based on the performance of the fund. If you take out a loan to buy the next best stock, you don’t get taxed differently than if you bought it with your own cash.

  • “Motivated by a sense of tax fairness?” Please. If this is the first area of the tax code Levin choose to attack, I question his sense of priorities. If it is the only area of the tax code he is attacking, I question his motives. As we know, most Congressmen/women’s priorities and motives have little to do with what is good and fair for the country.

    Looking at all the legislation Levin introduced in the 108th and 109th Congress, I would conclude that he is more concerned with the people of the Ukraine than anything else since 33% of his bills involve Ukrainian issues as opposed to tax legislation. In two sessions of Congress, I see one bill he introduced regarding the tax code.

    H.R.561 : – To waive time limitations specified by law in order to allow the Medal of Honor to be awarded to Gary Lee McKiddy, of Miamisburg, Ohio, for acts of valor while a helicopter crew chief and door gunner with the 1st Cavalry Division during the Vietnam War.

    H.R.562 : To authorize the Government of Ukraine to establish a memorial on Federal land in the District of Columbia to honor the victims of the manmade famine that occurred in Ukraine in 1932-1933.

    H.R.769 : To amend title 36, United States Code, to grant a Federal charter to the Ukrainian American Veterans, Incorporated.

    H.R.1170 : To authorize the extension of unconditional and permanent nondiscriminatory treatment (permanent normal trade relations treatment) to the products of Ukraine, and for other purposes.

    H.R.2058 : To amend titles XVIII and XIX of the Social Security Act and title III of the Public Health Service Act to improve access to information about individuals’ health care options and legal rights for care near the end of life, to promote advance care planning and decisionmaking so that individuals’ wishes are known should they become unable to speak for themselves, to engage health care providers in disseminating information about and assisting in the preparation of advance directives, which include living wills and durable powers of attorney for health care, and for other purposes.

    H.CON.RES.243 : Expressing the sense of the Congress regarding dispute settlement proceedings in the World Trade Organization.

    H.CON.RES.254 : Expressing the sense of Congress that the 70th anniversary of the 1932-1933 man-made famine in Ukraine (“Holodomor”) should serve as a reminder of the incredible suffering and loss sustained by the Ukrainian people as a result of intentional policies implemented by the government of the former Soviet Union.

    H.RES.121 : Endorsing increased efforts to preserve and protect Lake St. Clair as a vital part of the Great Lakes system.

    H.R.369 : To waive time limitations specified by law in order to allow the Medal of Honor to be awarded to Gary Lee McKiddy, of Miamisburg, Ohio, for acts of valor while a helicopter crew chief and door gunner with the 1st Cavalry Division during the Vietnam War.

    H.R.591 : To authorize the Ukrainian Congress Committee of America to establish a memorial on Federal land in the District of Columbia to honor the victims of the Ukrainian famine-genocide of 1932-1933.

    H.R.1239 : To provide for emergency unemployment compensation.

    H.R.1615 : To amend title 36, United States Code, to grant a Federal charter to the Ukrainian American Veterans, Incorporated.

    H.R.1744 : To amend title XIX of the Social Security Act to revise and simplify the transitional medical assistance (TMA) program.

    H.R.1860 : To promote primary and secondary health promotion and disease prevention services and activities among the elderly, to amend title XVIII of the Social Security Act to add preventive health benefits, and for other purposes.

    H.R.2308 : To amend the Trade Act of 1974 to provide trade adjustment assistance for communities, and for other purposes.

    H.R.2736 : To amend title VII of the Tariff Act of 1930 with respect to determining certain antidumping calculations for merchandise from former nonmarket economy countries.

    H.R.2737 : To amend the Trade Act of 1974 and the Sherman Act to address foreign private and joint public-private market access barriers that harm United States trade, and to amend the Trade Act of 1974 to address the failure of foreign governments to cooperate in the provision of information relating to certain investigations.

    H.R.3438 : To provide for programs to increase the awareness and knowledge of women and health care providers with respect to gynecologic cancers.

    H.R.3958 : To authorize the extension of unconditional and permanent nondiscriminatory treatment (permanent normal trade relations treatment) to the products of Ukraine, and for other purposes.

    H.R.4152 : To amend section 337 of the Tariff Act of 1930 to make unlawful the importation, sale for importation, or sale within the United States after importation, of articles falsely labeled or advertised as meeting a United States Government or industry standard for performance or safety.

    H.R.4450 : To authorize the Government of Ukraine to establish a memorial on Federal land in the District of Columbia to honor the victims of the Ukrainian famine-genocide of 1932-1933.

    H.R.5026 : To require the President to take certain actions to enforce the textiles and apparel safeguard with respect to imports from the People’s Republic of China.

    H.AMDT.301 to H.R.2799 An amendment to prohibit the U.S. Trade Representative from expending funds made available in this Act for negotiating a Free Trade Area of the Americas (FTAA) or a Central American Free Trade Agreement (CAFTA), that does not protect against piracy of copyrights; open markets for United States agricultural products, and high techonology and other manufactured exports, provides greater rights for foreign investors than Americans in the United States, and that does not require adoption and enforcement of the basic prohibitions on exploitative child labor, forced labor, and discrimination, and guarantee of the right to associate and bargain collectively.

    H.AMDT.544 to H.R.4359 Amendment in the nature of a substitute sought to make the existing child tax credit permanent, indexed to inflation; make the tax credit available to families making less than $110,000; accelerate the increase in the refundable portion of the credit, from 10 percent to 15 percent; provide the tax credit to low income individuals; and offset the costs of the bill with an additional tax on high income taxpayers.

  • Levin interview shows he does not understand tax code that he wants to change:

    The gain on stock options is NOT ordinary income. Whether non-statutory, or normal, options or most qualified ISOs, the “ordinary income” piece is the difference b/w FMV of asset/option and what you paid for it Then — having established basis (and paid income tax) on the option/property you received as compensation — when you exercise option and subsequently sell (or, often, simultaneously exercise option and sell) the stock there is capital gain (or loss). In simultaneous exercise/sale, the cap gain/loss may be short-term and taxed at same rate as ordinary income, but still capital gain/loss.

    Hypo Example:
    Receive: Stock Price when “own” Option = $10
    Sale: Stock Price when sell stock (after option is exercised) = $15

    Alt A: Exercise price = $8
    $2 of Ordinary Income (when you receive option as form of income) = difference b/w FMV of $10 and what you pay for it, or $8 (for simplicity am ignoring the Blalck-Scholes option value).

    $5 of Capital Gain (either short or long-term if 1 year after exercise) = difference b/w Sale Price of $15 and your basis, or $10 in this case, which is the $8 exercise price PLUS the $2 of ordinary income that you paid INCOME tax on.

    If $.01 Warrant example, then Ordinary income equals roughly the $10 FMV when get/own the option, and Cap Gain of same $5, as basis is the full $10 of Ordinary Income that you paid INCOME tax on.

    Bill sponsor doesn’t even understand tax treatment of his “analagous reasoning.”

    If you want to follow the stock option model, then gonna have to:
    (1) treat the “carried interest” as an option;
    (2) determine FMV of the option, with ordinary income as difference b/w that FMV and what you paid for the option (every Fund structure I’ve ever seen has a capital investment, e.g. the GP 1%, paid in respect of the carried interest);
    (3) determine when you own it (most PE/VC firms have vesting arrangements for particpation in the carry, just like with ISOs) and/or have “constructively” exercised the option;
    (4) then determine cap gain or loss (they aren’t all winners you know) when you sell or realize gain/loss on your basis (which will be total of the GP capital investment plus any “ordinary income” realized when you received the “carried interest option”.

    Any they wonder why they’re called talking heads full of media bytes signifying little but sound & fury.

  • REASONS to tax carried interest as long-term capital gain as opposed to ordinary income:

    1) Carried interest is “at risk.” If the fund doesn’t perform there is no carried interest. Salary is paid whether an investment does well or not. Also, don’t forget that carried interest only kicks in after management fees are “paid back” and a hurdle IRR is provided to LPs. It would be fundamentally different is there was no contingency based on performance.

    2) The way I understand sweat equity is that you have “paid” for your shares through sweat/service.

    3) Carried interest is in the best interest of the investor because it provides an incentive (“carrot”) for fiscal responsibility. Why decrease the carrot (especially a market driven one)? Salary provides no carrot. (i.e. no skin in the game). LPs do not want to see GPs incentive decreased so all of the economics would probably just shift around to conform to the new tax environment (i.e. nothing would really change). The difference would come out the LPs pockets (pensioners, policyholders, endowments – the little guy).

    4) How do you reconcile the fact that fund managers should pay ordinary income rates on their pro-rata share of a pie while the rest of the shareholders pay long-term capital gains rates on the same pie (especially a “founder”)? Why should a “founder” of a fund be any different than a “founder” of any other type of company? Especially if finance and other “knowledge workers” are supposedly the future of the American economy. How many of your friends are starting a manufacturing company? Don’t we want to encourage entrepreneurship? I can start/be an owner of a fund or I can start/be an owner of a manufacturing business competing with China/owner of a service business in the midst of an astounding skilled labor shortage. I chose the fund business knowing my upside (“carry”) was not without risk (investing in the aforementioned companies). I knew the carry would be 5 years out or longer and I would have to work very hard and be very disciplined in an overheated market. I can get by on salary but the carry is what is going to put the kids through school. How is my situation that different from someone who starts a company worth zero and builds it up over time? Founders equity is founders equity no matter what the enterprise does.

    5) Has anyone pointed out the difference that hedge fund managers are typically bonused out their carry (based on Mark to Market valuations that may and probably will decrease) at the time an investment is made or at least on an annual basis as opposed to PEGs who only see it at the end of the investment horizon? This makes it short term and non-contingent. Do you know how this is treated for tax purposes currently?

    6) Has anyone drawn a comparison to oil & gas and real estate investment carried interest? This has been around much longer than private equity carry and provided the model for PEGs. You can bet congress doesn’t want to bring the oil lobby into this fight. I would suspect Senator Levin would have to “get back to you on this – the dog ate my homework.”

  • The IRS currently taxes capital gains at a lower rate for two reasons, neither of which has to do with compensating entrepreneurs for their risk (as many have argued). Instead, capital gains tax treatment is very logical and fair. But why would logic matter in a democratic congress?

    First, taxes on capital gains represent double taxation (distributed gains have already been taxed at the corporate level, likely at 35%). As a result, capital gains taxpayers are paying implicit and explicit taxes that together exceed 35%.

    Second, capital gains often result from improved profitability – a company increases it cash flows / earnings and in return fetches a higher sale price. The increase in profitability represents a taxable revenue stream for as long as it is maintained. This is the main reason why capital gains are taxed at a lower rate – so that business people are provided the incentive to create new profit streams for the IRS to tax! How much in taxable profit did Schwarzman create in order to generate his $7+ billion?

    Modifying how capital gains are taxed will have disastrous effects on our economy. The only reason it is being contemplated is because democratic congressman see it as a way to win votes. It’s just another Robin Hood tactic.

  • Just a few thoughts on some of the points mentioned above:

    1) Carried interest is a performance-based compensation (as mentioned above), in the same vane that a bonus is performance-based – yet bonsues are taxed as ordinary income, so why shouldn’t carry?

    2) Regarding the arguement that the GP is “at risk” – that is simply not true for the majority of the capital we are discussing. Throw away the issue of the GP commitment, as it is typically a small component of any fund. The VAST majority of carried interest proceeds are generated from other people’s capital at risk. Fi you want to argue the issue of those gains being allocated to the GP, fine. But don’t try ot argue that the 20% carry comes from the GP’s capital at risk.

    (An analogy – I would “allocate” all of my compensation to my 6 year old and get a better tax treatment, if I could.)

    3) Many funds are set up where the GP entity enters into an Investment Advisory Agreement with the individuals. This agreement lays out the payment the GP entity will make to the individuals, including fees and carried interest. So, in essence, there is a service being provided to the GP by the investment advisor, and therefore should be treated as service income, thus taxed as ordinary income.

    4) To the point made above about recent times when GP’s had to disgorge capital back to LPs when the market tanked, that was because the GP took carried interest gains early, and as a result had to give it back when, at the end of the day, the ultimate profit of the fund didn’t call fro teh GP to take as much carry as they did. It had NOTHING to do with the GP’s own money in the fund (if the GP took the money and spent it without thinking about the possible clawback consequences, that was his fault for not being prudent).

    Would I like carry to be taxed at cap gains rates? Absolutely. But until someone gives a legitimate rationale for why the allocation of gain from someone else’s capital, I don’t see this ending positively.

  • Dan, I must be missing something.

    Capital gains are not “double taxed,” you’re confusing them with dividends paid from retained earnings (which most firms avoid by simply borrowing the money to pay dividends).

    WRT to your second point, does this mean that you would be okay with taxing gains resulting from leverage or muliple expansion at the normal income tax rate?

  • “C,” you didn’t mention (WRT to your point #4) that GPs typically structure clawbacks so that they are net of tax (e.g. the LPs eat any adverse tax consequences resulting from the GP’s taking an early distribution). I’m not sure which is more troubling, the fact that GPs do this, or the fact that LPs let them; regardless it’s just one more example of how good GPs are at shielding themselves from any risk.

  • GP, carried interest not being a foregone conclusion is identical to saying a performance bonus is not a forgone conclusion. BTW, are you insinuating that how you are taxed on performance bonuses classifies you as a socialist or a capitalist. Most bankers, corporate execs and “pure capitalists” (those based on commission sales for example) are probably more capitalistic in spirit than some one making money on someone else’s money where the risk is whether they make mid-high 6 figures or 7 figures. The prior group all get taxed as ordinary income on performance based bonuses. They are not socialists because of this fact.

    In the end the question stands: how many VCs are going to quit over this??? Are you? Further, as long as the portfolio company (remember these guys…the REAL drivers of value) produce value money will flow to them independent of how the investing professional is taxed.

    Finally, as long as the VCs are taxed (ordinary tax rate) on the value of the in-kind compensation disbursed to them I think there is no problem. If they chose at that point to let their in-kind holding suffer the risks of the market then they should only get taxed as capital gain for any gain ABOVE the disbursement basis value. Because then they are truly risking their capital….

  • Nice site. Thanks.
    http://www.bloggerblast.com/cheapviagra viagra

  • Good site. Thank you:-)
    http://www.bloggerblast.com/orderviagrausa order viagra

  • Nice site. Thank you:-)
    http://www12.asphost4free.com/bestone/fergie fergie

  • Nice site. Thank you.
    http://www12.asphost4free.com/bestone/rihanna rihanna

  • Nice site. Thanks:-)
    http://www12.asphost4free.com/bestone/loans student loans with bad credit

  • Good site. Thank you!!!
    http://www12.asphost4free.com/bestone/nickelback nickelback

  • Nice site. Thank you!
    http://www12.asphost4free.com/bestone/bad-credit-personal-loans personal loans bad credit

  • Cool site. Thanks.
    http://www12.asphost4free.com/bestone/student-loan-forgiveness student loan forgiveness

  • Very good site. Thank you!!!
    http://www12.asphost4free.com/bestone/bad-credit-loan personal loans for bad credit

  • Very good site. Thanks:-)
    http://www12.asphost4free.com/bestone/bad-credit-car-loans bad credit car loans

  • Nice site. Thanks!
    http://www12.asphost4free.com/bestone/bad-credit-mortgage mortgage loans for bad credit

  • Good site. Thank you:-)
    http://tramadolnow1.forum24.se tramadol

  • Cool site. Thank you:-)
    http://gds.clan.su/index.html Craigslist Seattle

  • Good site. Thanks!!!
    http://replicarolex.createmybb.com replica rolex

  • Good site. Thank you!
    http://phentermine1.forum24.se phentermine

  • Nice site. Thanks!!!
    http://hometown.aol.com/maraa242/craigslist/index.html craigslist seattle

  • Good site. Thank you.
    http://hometown.aol.com/maraa242/refinance/index.html refinance home mortgage

  • Nice site. Thank you.
    http://hometown.aol.com/maraa242/mortgage home loan mortgage rate refinance

  • Nice site. Thanks!
    http://hometown.aol.com/maraa242/delta/ delta airlines

  • Very good site. Thank you.
    http://hometown.aol.com/maraa242/credit/ free credit scores

  • Very good site. Thanks:-)
    http://hometown.aol.com/maraa242/lending/ home loan lending

  • Good site. Thanks!
    http://hometown.aol.com/maraa242/rolex/ rolex

  • Nice site. Thanks!
    http://www12.asphost4free.com/top101/consolidation/ federal student loan consolidation

  • Good site. Thanks!
    http://www12.asphost4free.com/top101/alltel free alltel ringtones

  • Cool site. Thank you.
    http://www12.asphost4free.com/top101/loan no faxing payday loan

  • Cool site. Thank you.
    http://www12.asphost4free.com/top101/loan no faxing payday loan

  • Nice site. Thank you!!!
    http://www12.asphost4free.com/top101/faxless faxless payday loans

  • Good site. Thank you!
    http://boarder-forum.powder4you.com/functions/insurance1.htm business insurance

  • Good site. Thank you!
    http://www.regio-hr.com/functions/loan1.htm auto loans

  • Cool site. Thanks:-)
    http://talkingtechs.com/functions/hydrocodone_vicodine.htm prescription hydrocodone

  • Cool site. Thanks:-)
    http://lachica.metropoliglobal.com/news/functions/cialis.htm cialis levitra sales viagra

  • Good site. Thank you:-)
    http://www12.asphost4free.com/10top/refinance/index.html refinance auto loan bad credit

  • Good site. Thanks.
    http://www12.asphost4free.com/10top/auto/index.html auto loans bad credit

  • Nice site. Thanks:-)
    http://hometown.aol.com/ipplaget/christ/index.html christian debt consolidation

  • Good site. Thank you:-)
    http://www.datingfunda.com/userspic/admin/functions/insurance3.htm insurance commissioner

  • Nice site. Thank you.
    http://phenterminenoprescription-dev.blogspot.com/ phentermine no prescription

  • Nice site. Thanks:-)
    http://www.bloggerblast.com/gaysexboys brother sister sex

  • Good site. Thank you:-)
    http://online-credit-counseling-free.blogspot.com/ free credit counseling

  • Cool site. Thanks.
    http://buyphentermineonline-tod.blogspot.com/ buy phentermine online

  • Very good site. Thanks!!!
    http://www12.asphost4free.com/bestone/loans student loans with bad credit

  • Cool site. Thank you!
    http://jc-penny.blogspot.com/ jc penney

  • Nice site. Thanks!!!
    http://www.freewebs.com/101top/index.html no fax payday loans

  • http://it.geocities.com/loansstudent bad credit student loans

  • http://it.geocities.com/phentermine.prescription phentermine without prescription

Leave a Reply

PEHUB Community

Join the 12500 members of peHUB to make connections, share your opinion, and follow your favorite authors.

Join the Community

Look Who’s Tweeting

Psst! Got any hot tips?

  • This field is for validation purposes and should be left unchanged.

PE HUB News Briefs

RSS Feed Widget

Marketplace

VCJ Headlines (subscribers only)

RSS Feed Widget

Buyouts Headlines (subscribers only)

RSS Feed Widget

Reuters VC and PE feed

RSS Feed Widget