It's a thin needle to thread, but venture capital and private equity companies, not to mention their even more rarefied hedge fund compatriots, are often small companies. They can also be creators of enormous wealth--for themselves and their investors.
Also unique to them are a number of tax loopholes for which the majority of small business owners don't qualify. Among these is so-called carried interest, which lets venture capital and private equity fund partners pay a lower long-term capital gains rate on their share of future profits from investments.
Lesser known is a vague tax loophole that allows the fixed management fee that funds charge to be counted with this carried interest, and taxed at the same lower capital gains rates. So in other words, they're able to skirt ordinary income taxes, as high as 39.6 percent, in lieu of paying a lower capital gains rates of around 15 percent. Opponents say such fees are essentially the firm's guaranteed paycheck, which managers get regardless of losses, so they should be taxed at higher ordinary rates.
These tax loopholes made headlines during the 2012 Presidential election when it came out that Mitt Romney, the former governor of Massachusetts and co-founder of private equity firm Bain Capital, has benefitted handsomely from such exclusions. But they're again drawing public scrutiny in New York, one of the biggest venture capital centers in the country.
But what happens in New York may not stay in New York. There's every indication that the state's Comptroller Scott Stringer will try to close these loopholes on Wall Street, and that could spark a national movement.
"You have some of the richest people in the country paying substantially lower tax rates than people who are much less well off," says Gregg Polsky, a professor at the University of North Carolina School of Law, who has written extensively on the carried interest provision.
Polsky adds that for the last five to 10 years, some in Congress have introduced bills that would close a number of loopholes. But those measures have fallen on deaf ears, as industry groups have fought legislation. (The National Venture Capital Association, one of the chief lobbying groups in favor of the current tax policy, did not respond to request for comment.)
Polsky speculates the Internal Revenue Service may soon get involved as well.
Still many venture capitalists and private equity fund managers claim the loophole is justified. Their argument? They put their money at risk for deals that may or may not work out.
"We invest our own money both at the limited partner level and the general partner level," says Jeff Kadlic, managing partner of Evoluton Capital, a small private equity fund in Cleveland. "If we lose, we don’t get that money back."
Kadlic adds that it's a fiction that all private equity managers are as rich as Midas. Most live middle to upper-middle-class lifestyles, he says.
Others, like Brian Hirsch, managing partner of Tribeca Venture Partners, of New York, say the current tax provisions are fair, because venture capital firms fund companies are drivers of economic growth.
"Increasing taxes for either entrepreneurs or the people and funds that back them is at best neutral and possibly negative," Hirsch says. "A proper analysis would take into account the significant increase in high quality job creation and the positive impact that has had on the tax coffers of New York City and New York State."
Closing the loopholes would result in $1.6 billion in additional tax revenue for the Federal government, according to Joint Committee on Taxation.