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The Taxman Cometh for VCs?

The tax structure that applies to VCs is under great review right now.  Fred Wilson is one of the few VCs that has come out in favor of taxing a VC's carried interest at ordinary income rates rather than capital gain rates.  Fred's never been afraid of controversy.

I think that capital gains treatment should apply when the investor risks their capital (time or money) in order to try to create a gain.  A VC's carried interest has no downside risk -- if they lose money on the fund, they don't have to repay investors out of their own pocket (nor should they).  They get a share of the profits, and not losses.  The limited partners in these VC funds have clearly risked their capital as they may not get their money back.  There isn't risk in the VCs carried interest, which is part of Fred's argument to tax it at ordinary income.  Note that this clearly should not apply to a VC's personal investment as a limited partner in the fund.  That investment clearly risks capital, and has to maintain capital gains tax treatment.

Don't assume that the tax code is consistent, however.  There are thousands of inconsistencies, exceptions and incentives in the tax code which encourage and discourage certain types of behavior.  Ask anyone subject to the creeping AMT if the tax code is fair.  So, although I think that consistency should be a goal, it obviously isn't a tax rule.

Also, VCs in smaller funds that don't draw big fees are risking their time to try to build companies in order to create gains for their investors and themselves.  If a VC earned zero salary and only made money if their investors made money, there might be more sympathy to keeping capital gains treatment for their carried interest.  Or, is this similar to a commission-only sales rep who pays ordinary income tax rates?  With huge private equity funds making tens of millions of dollars in risk-free fees for their partners, it's hard to see the risk that those general partners are taking in any case.

In addition, I don't like changing the rules on an investment vehicle once it's in place.  That deal was done with a certain set of tax structures, and it isn't fair to change the rules.  So, any tax changes should only apply to new fund vehicles put in place after the changes take effect.  Existing funds should be grandfathered, but care should be taken that these funds can't be extended in order to preserve the grandfathering.

So, what to do?  I think it is hard to make a blanket change.  Risk needs to be rewarded, whether it is time or money risked.  And, the system shouldn't be changed without ensuring that the venture capital and private equity models are preserved.  They add a lot of value to the economy and have created wealthy investors, VCs and entrepreneurs.  So, I hope Congress proceeds with caution.  Let's hope something comes up to take the heat off this issue in the public eye so change can be more deliberate.

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