Tucked away on Page 139 of Obama’s American Jobs Act, after the sections on payroll tax credits and unemployment benefits, are a few lines of text that could change the way venture capital investment works in this country.
As it is currently written, the American Jobs Act would require venture capitalists to start paying higher taxes on “carried interest,” the share of profits they receive when an investment is taken public or sold. Currently venture capitalists pay a tax rate of as little as 15 percent on carried interest because it is treated as a capital gain. Under Obama’s plan, though, it would be taxed as regular income at a rate as high as 35 percent. The carried-interest proposal isn't limited to VC funds; it also embraces all investment partnerships, including hedge funds and other kinds of private equity funds.
Why include this change in the Jobs Act? The administration projects that the higher tax rate would contribute $18 billion in new revenue to help pay for the Act's spending initiatives. In addition, carried interest has long been targeted by Democrats as an unjustifiable tax break for wealthy speculators, particularly hedge fund managers. The Dems point out that a hedge or private-equity fund manager or VC does not risk any of his or her own capital to earn carried interest; it represents nothing more than a share (usually 20 percent) of the return on the fund investors' capital. In that way, the Administration argues, carried interest is akin to a performance bonus, not a capital gain, and therefore deserves no special tax treatment. It's a fairness thing.
Many VCs and their allies retort that it's actually a pragmatic thing. In an economy starved for jobs and growth, Washington has no business raising taxes on the people who create both. The inevitable result, they claim, will be less of what the economy needs most. They also believe that Adminstration estimates of new revenue is exaggerated.
“Changing carried interest for venture capitalism is not going to help job creation or the economy as a whole and certainly is not going to bring any significant tax revenue,” says Mark Heesen, president of the National Venture Capital Association, the industry’s leading trade association.
VCs warn that if the tax increase happens, it could also further damage an industry that has yet to recover from the Great Recession. Invested venture capital, which reached $30.4 billion in 2007, stood 30 percent lower last year at just $23.3 billion.
“Everybody talks about innovation, but the true forefront of innovation is venture capitalists and entrepreneurs. I don’t believe anyone in Washington, D.C., knows how fragile that ecosystem is," says Josh Green, a partner at VC firm Mohr Davidow. Supporters of the jobs bill reply that since it won't take effect until tax year 2013, it won't stand in the way of the industry's recovery.
Even so, the risk of failing to fund tomorrow's most innovative companies isn't worth the extra tax revenue, says Mark Cannice, a University of San Francisco professor who studies venture capitalism. “Maybe that one company who didn’t get invested is the next Google. Or the next Apple. You’ll never know who isn’t getting invested.”
If faced with higher taxes, venture capitalists might try to preserve their profit margins by sqeezing investors or the owners of funded companies. For instance, instead of asking for a 20 percent share of investors’ return, VCs might raise the fee to 35 percent, says Jerome Engel, a University of California-Berkeley professor. Alternatively, they could increase their fixed annual management fees, or seek stock options instead of carried interest from portfolio companies, or insist on being able to buy shares at a discount, says Matthew Rhodes Kropf, a Harvard Business School professor of venture capitalism.
Obama sent his jobs plan to Congress in September and has continued to campaign across the country to drum up popular support. Next step: The 12-member super committee charged with deficit reduction will examine the proposal as well as recommendations from House and Senate committees. It is expected to make a decision in November.
Whether the carried-interest tax increase is still part of the bill at that point depends in part on how it’s framed to Congressional Republicans, says Jerome Engel, a University of California-Berkeley professor. If it’s presented as another tax increase, they’ll balk. If it’s described as one of a number of loopholes that need closing, it stands a greater chance, Engel says. “The Republicans said that they might allow loopholes to be closed,” he says. “If it’s perceived as a loophole, it may get lumped in with bigger issues.”
One irony of the new tax rule is that it largely misses the people it was aimed at--hedge fund managers, the speculators everyone loves to hate. Since many hedge funds earn their profits on investments held less than a year, they were never major beneficiaries of the carried-interest tax preference in the first place. Democrats don't feel the same enmity towards the real estate partnerships, private equity and venture capital firms that would share the brunt of the proposed change. "Should venture capital pay more taxes at some point? Yes maybe," says Cannice, "But I think you want to be careful how you support and burden the industry because it's kind of been the goose that lays the golden eggs for the country."