Thanks to a booming private equity market, it's still a great time to raise capital for your business. But what's been overlooked in the wave of deals, funds and leveraged buyouts is a small but significant irony in the tax code. Turns out that if you're looking to shrink your tax bill, it can be better buy or invest in companies than to actually start them.
As The New York Times points out today, because of a peculiar wrinkle in the tax code, the managers of private equity firms (including venture capital firms and hedge funds) are largely taxed at a capital gains rate of just 15 percent. Congress is currently considering a bill that would change this loophole, but it's unclear that the bill will actually make it out of committee.
Here's a little more detail: the managers of private equity funds typically are paid at a "2 and 20" fee structure. In other words, they are paid an annual fee equal to 2 percent of the total money they manage and 20 percent of the profits they generate. The catch is that the 20 percent of profits fee is taxed as a capital gain (15 percent), while the 2 percent management fee is taxed as ordinary income (35 percent). The result? A good portion of a private equity manager's cash earnings are taxed at a 15 percent capital gains rate rather than the typical 35 percent ordinary income rate. When a private equity investment hits it big — think of an early investor in Google — they're receiving a tax discount that could be potentially worth millions.
Consider the other side of the coin. An entrepreneur taking home significant cash from his or her business will usually get taxed at that dreaded 35 percent income rate. A fund manager, on the other hand, gets a good portion of their income at a 20 percent discount.
Sound unfair? Well, there are a wide variety of views out there on this. Here are some of the best: Fred Wilson, an early stage venture capitalist and inveterate blogger argues that the tax rate should be revamped. His business partner, Brad Burnham, is a little bit more circumspect. The Wall Street Journal, not surprisingly, came out against the bill currently in front of Congress. There's also a really excellent explanation of the issue here by Daniel Shaviro, a professor of taxation at New York University Law School.
Much smarter people than I will be able to parse out the actual economic effects of this tax loophole, but it's hard to make an argument that the current tax structure is fair for entrepreneurs. Today's venture capital funds are larger than ever. The average VC fund is worth about $300 million, according to the National Venture Capital Association, so it's fair to say that management fees haven't lagged either. Fund managers, after all, get paid even if there investments fail. Entrepreneurs should be so lucky.
Do you think Congress should change the way private equity firms are taxed? Will doing so slow down the private equity boom?