The Blade

Why This Tax “Loophole” Could One Day Affect You

On Sunday night, Donald and Hillary debated “carried interest.” Trump and Clinton both said they want to eliminate it. What is carried interest and how does it affect startups? Simply put, on the surface, carried interest is one of the many self-serving-for-rich-people tax loopholes. But let’s dig deeper.

What is carried interest?

Carried interest is a 50-year-old tax provision that allows executives at venture capital, private equity, real estate, and other partnerships to classify much of their income as capital gains. Long-term capital gain (e.g., purchasing an asset for $1,000,000 and selling it for $1,500,000) is taxed federally at 20 percent. Earned income is taxed between 28 and 40 percent.

How do execs pull this off? Their agreements with investors state that 80 percent of their portfolio gains go the investors, and 20 percent go to the executives, a.k.a. “carry.” The carry is taxed as capital gains. But keep in mind, their 20 percent cut is clearly “income” because they aren’t risking their own money; their job is to invest other people’s money.

So a school teacher, fireman, attorney, accountant, garbage man, sole proprietor, and a salesperson–or whatever “normal” profession–pay higher tax rates for the income they make from doing their jobs. Hence, the now-famous Warren Buffett comment that it’s unfair that he pays a lower tax rate than his secretary. Buffett’s tax situation is more complex, but carry is one example of his point.

A rigged tax code? Maybe, maybe not

At this point, you might be a little enraged (understandably). The rich get richer and get all the breaks! True. But wait! Hold on. If you’re a founder of a startup and before you become too pissed off, make sure you fully understand the venture capitalists’ counter-point because this affects YOU.

Here is what Bobby Franklin, president and CEO of the National Venture Capital Association (which means he’s a lobbyist) had to say about Donald Trump’s plan to eliminate carried interest:

“…Far from being a so-called ‘loophole,’ the carried interest venture investors receive is similar to stock awards received by the founders of a startup in that both the venture investors and founders commit the time, energy, and creativity against huge risks to build new startups into successful companies.”

Ahhhhhhhh. The plot thickens! Lobbyist are also good at their jobs, aren’t they? They remind us of issues and ramifications that maybe we haven’t considered. In 2007, when I sold First Research, I also benefited from capital gains. In fact, I recall having to pinch myself to make sure I wasn’t dreaming because I had invested $30,000 to start First Research, and eight years later, sold it for $26.5 million – and my gains were taxed federally at just 20 percent. And building First Research was my job. Of course I risked my own money (a whooping $30,000), but most of the gains were due to effort, not my risk of capital.

Mr. Franklin says that VCs also commit themselves to helping build companies; they are active on boards; they build connections for successful startups; and they advise the founders. So, he argues, VCs deserve the same tax benefits as other investors.

Encouraging monetary movement

Now I’m about to make this issue even more complex. One main reason that long-term capital gains are taxed lower than income is because if investment gains are taxed too high, then investors will be discouraged from selling their assets and moving their money to more efficient places. Keep in mind, if you sell an asset and have to pay huge taxes on the gain to Uncle Sam, you have to buy something else that is really, really productive; otherwise you should just keep your inefficient asset. This dynamic would be really bad for a capitalistic economy because money would remain in efficient places instead of moving around.

How you feel about carried interest is up to you. But keep in mind, these issues are very complex. Contact your congressman today and express your feelings about it. But be careful: It’s a slippery slope, and if you are a startup founder, one day you might be paying income taxes on your own capital gains!