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"And it is a capital gain because those individuals do make an investment, it’s a small investment, but they make an investment of their own capital..."
If anyone is mistaken on this issue it is Congress by not recognizing that the general partners are in fact participating in the fund as an investor, not just a manager.
Bill, Kevin, Jeff, come on, you know that profits from the portion on the personal money invested gets capital gains. Why should a VC get capital gains on carried interest, when the VC is investing someone else's money? In fact, one could argue that the chief reason the VC is getting nice profits on his personal investments in the fund is because he's leveraging other peoples' money (creating a large enough fund to invest in lucrative business ventures), including in some cases money from the state of California or public pension funds. If it weren't for regular tax payers and other pensioners, Bill, you may not have a venture fund right now. You deserve capital gains on the profits your personal investment Bill, because that's your risk. It should be encouraged. But not on the profits that the rest of us (state, public and private institutions) are helping you get. On that, you deserve to pay the personal income tax that me and the janitor at the local supermarket are paying.
It appears you'd like to change the discussion away from the merits of your story, to the broader subject of taxation on carry itself?
His nuance here was to repeat one of the basic "academic" foundations of carry as capital gain...that the GP indeed has capital at risk alongside the LPs (even though that capital is usually small).
His use of "capital gains" might be easier to understand if he instead said "I would treat the GP's allocation of carry as capital gains"
Your headline was misleading and stems from the fact that you misunderstood Romney. THAT's what Bill said, and I agreed with him.
I know you're dying to rip into the whole "they still get capital gains on the money they risk themselves!" angle, but that misrepresents the point of Romney's statement. His opinion is that it is still a capital gain by definition for the fund, so he favors letting those GP investors get taxed on the carried interest portion of the capital gain as a capital gain. Regardless of your opinion on the tax treatment, there is no debating that the carried interest itself is by definition a capital gain within the fund.
Your argument is that the carried interest should not be treated as a capital gain for the GP as it is not associated directly with the GP's capital risk in the fund. Sure, the amount of capital they risked is not equal, but their role isn't the same as an LP either. The LP contributes capital and walks away. The GP risks more than their capital (the opportunity cost of getting paid more money in guaranteed salary/publicly traded stock options to do something else), and they contribute more than cash to the fund (time, analysis, knowledge, contacts, and strategy). That is how they have "earned" a larger portion of the fund's capital gain that can far exceed their capital contribution percentage and management fee allocation. If they hadn't earned more of the capital gain, the free market wouldn't let them structure the funds the way they do.
Rational business people can debate the merits of re-defining capital gains as personal income for tax purposes under different circumstances. I think you are overstating the strength of your argument to change the tax treatment, and you're not giving Romney a fair shake on his statement either. There is nothing in his quote that would clearly show he does not understand this issue. If anything, I think it shows that Romney and others who support capital gains treatment have not done a very good job of explaining the merits of their position on a complex subject. Journalists like yourself view this in fairly simple terms: percentage of capital risked equals percentage treated as capital gains on your tax return. Romney, and many others, do not see it the same way.
Sorry to see that you guys were fighting over here and I didn't realize it soon enough to get in the mix!
Just to clarify my personal conflicts, I have a hedge fund now, so I generate little if any capital gains; I am mixing it up with you because I just like a good argument! (Although I still have an interest in my old fund, so I guess I am indeed conflicted after all... oh well)
I still think if you look at Romney's quote it doesn't indicate that he doesn't understand the issue, it just indicates that he supports the status quo. I think the problem that you (and Dan over at PE Week) have with his statement is you see his statement as misleading because he implies that there is capital invested to produce carried interest and you guys don't believe that to be true despite what the IRS may say. To me that's debatable and subjective and simply indicative that Romney has learned the politician's art of presenting his position in the most favorable light possible.
To leave Romney aside and address the heart of the matter, let me basically reprint part of an e-mail I sent Dan on today when we were having a gentleman's debate on the topic:
"When an entrepreneur gets 20% of the economic interest in a company, yet invests well less than 1% of the actual capital, everyone seems to get that concept with no problem, but when a VC does the same thing everyone acts perplexed and seems to think this is some kind of unnatural tax dodge.
If the VC is just getting returns for investing "someone else's money" what in the world do you think the entrepreneur/manager is getting those out-sized returns for??? Both VCs/PEs and entrepreneurs/managers create businesses that try to earn a return on invested capital. Both take risk to do it (and incidentally both get salaries for their time in addition to their capital ownership). Why is taking the risk to start a business that invests capital in financial assets any different than taking the risk to start a business that invests capital in operating assets? Both businesses invest other people's money and both managers receive an economic interest in the business that is disproportionate to their contributed capital. Fact is, a successful economy needs both sets of managers badly as there is a deep symbiosis between them, therefore why shouldn't the government support both with the same tax treatment?
I think much of the opposition to carried interest tax treatment is based on somewhat latent, deep seated populist and socialist sentiments that hold capitalism and for that matter most of modern finance in moral contempt. This contempt stems largely from the abstract, opaque nature of modern finance as well as the great wealth it has produced, but also from either genuine or willful ignorance about the importance of capitalism and modern finance to overall economic growth and human prosperity. Without sophisticated financial entities (and their managers) that are willing to take risks the economy would be far smaller and the overall standard of living throughout the world would be a lot lower.
It seems to me that one can argue whether or not preferential capital gains tax treatment, in general, is a good idea, but to split hairs and say that one set of managers (corporate guys, entrepreneurs) deserve it, but another set of managers (VC, PE guys) do not, evidences both a fundamental lack of appreciation for just what financial managers do within the context of a modern economy but also a willingness to sustain a clearly illogical and contradictory position in order to maintain some romantic, populist and dated notions about the relative social value of different kinds of labor."
While this is obviously a provocative way to make the case and I don't mean to imply you are a socialist :-), I think the fundamental reasoning stands: there is little theoretical difference between a VC fund and a tech company. The managers at both entities receive disproportionate economic interests relative to their capital contributions and invest other people money's, one in financial assets, the other in operating assets. Both create long term economic value (hopefully) and promote economic development. Why one set of managers should be deserving of capital gains treatment but the others shouldn't just doesn't make logical sense. Opposition to financial managers receiving capital gains is largely emotional and political and rests on the assumption that investing in financial assets isn't "real work" and somehow is less important or less noble than investing in operating assets. Personally I think both are crucially important and don't see anything unfair or illogical in extending the same tax treatment to both and I say that with a straight face despite my obvious self-interest!
Now if we want to have a serious debate about overhauling the entire tax system, that's another issue.... Here's a radical idea I heard recently: Eliminate all corporate taxes. But institute a simple, yet progressive personal income tax, with the total tax tied to the national budget averaged over some number of years, with no distinction between income from labor and income from passive investments.
I could care less that "accounting wise" and "tehnically" a fund treats carried interest as capital gain . . . the rules could be changed and thus the argument no longer holds.
Entrepreneurs get common while vc's gets preferred . . . two very different equity with very different RISK profile . . .
Bill is right that in many ways the human capital that a VC provides is similar to the human capital that an entrepreneur provides. Conceptually (i.e. in theory), we should also tax a portion of the founder's gains as ordinary income (say, an amount equal to the opportunity cost of his foregone salary) with capital gain on further appreciation. As a practical matter, this would be difficult. However, the fact that we don't tax founder equity as ordinary income, in full or in part, isn't enough reason not to tax the labor element of carried interest correctly.
Am I advocating higher taxes, for the sake of higher taxes? No. We're talking about justice here, and having a system where all people pay income tax on the profits they make by rendering a service. Separate from that, they should pay a lower capital gains tax on profits from investments of their money risked in order to secure long-term gains.
Matt, you hurt your credibility by bringing "justice" into the equation here. That's a very subjective term and raises this debate from technical to emotional. The carried interest is not earned service revenue like your janitor example. It is a capital gain. The only question is whether or not that kind of capital gain should get capital gain tax treatment like it always has under US law, and as it is currently treated in most other first-world countries (e.g. Germany lowered taxes on carried interest in 2004 to be competitive with tax treatment in other European countries and to encourage more capital investment).