Carried Interest Deal Cut, Let the Workarounds Begin! UPDATE: Some More thoughts
So Congress has apparently cut a final deal on taxing carried interest. According the Way and Means Committee the bill will:
" … prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as carried interest in an investment fund. To the extent that carried interest reflects a return on invested capital, the bill would continue to tax carried interest at capital gain tax rates. However, to the extent that carried interest does not reflect a return on invested capital, the bill would require investment fund managers to treat seventy-five percent (75%) of the remaining carried interest as ordinary income. A transition rule would apply prior to January 1, 2013. This proposal is currently being estimated by the Joint Committee on Taxation.”
This compromise drops all pretense about this debate being a principled argument over tax/investment policy and makes it clear it's just about raising cash, which I guess is fair enough. A couple quick points:
- As far as I know, no GPs get “carried interest” on their own invested capital in the fund, so the exemption for that is basically worthless.
- The final solution of taxing carried interest at 75% of ordinary income is obviously just a political compromise to get the deal done. What they are really doing is raising the tax on carried interest from 15% to 26% (29.7% starting in 2011).
Where There’s A Will There’s a Way
The fundamental problem for the government is that carried interest isn’t given to VCs by GPs for the hell of it, it is given to them because the VCs are investing all of their intangible assets (reputations, track records, networks, etc.) into each deal. LPs have traditionally valued these intangible assets enough to give VCs a 15–35% ownership stake in the partnership. The carried interest legal/tax structure just represented the most straight forward way, least hassle way to account for all of this. By putting this option at a significant tax disadvantage, the government is just going to force VCs and Private Equity firms to create more elaborate documentation of this, until now, implicit arrangement. My guess is that after this law goes into effect will we see VC deals restructured into something along the lines of this:
- Step 1: Create special purpose LLC
- Step 2: LP contributes $X
- Step 3: GP contributes $Y
- Step 4: GP contributes non-exclusive trademark license, promotional agreement, strategic partnership agreement, venture services agreement, and other such intangible assets as it deems appropriate in return for 15–35% of equity in SPE
- Step 5: SPE invests $X+$Y in portfolio company.
These kind of structures will cost more to set up and maintain, but they will be very hard for the IRS to attack because the VCs are getting equity for the contribution on clearly identified assets.
Now some might say, these “assets” are intangible assets and therefore the IRS will be able to claim they are bogus, but the problem for the IRS is that there are a ton of deals, outside of venture investments, that are structured exactly this way, especially in areas such as pharma and entertainment, where different parties contribute intangible assets in lieu of cash for ownership stakes. For example, there are a ton of pharma and biotech JVs and investments made by simply contributing intellectual property (patents, research, data, etc.). Thus this change is likely to set off a cat and mouse game between lawyers and tax accountants and the IRS with the only real winners being, as usual, the lawyers and the accountants (Hey start-ups, that $30K you pay to close your Series A, just went to $100K!).
Hollywood Holds The Key
All that said, since this whole exercise is really just about extracting cash, one would assume that Congress will amend the law to try and cut off whatever workarounds are developed. The key for VCs then is to choose a workaround that Congress can’t/won’t cut off because it hurts another powerful political constituency they aren’t trying to shake down. Enter Hollywood.
From what I understand, the entertainment industry has created tax and legal structures that would put any VC lawyer to shame. Contribution of intangible assets (such as development rights, creative services, trademarks, etc.) for equity is apparently widespread. After all, lots of people want to invest alongside successful Hollywood producers/directors/actors and are happy to give up a big cut of deal to draft off of these people’s reputations, project sourcing, creative talent, etc. It also happens to be that Hollywood is major source of Democratic campaign contributions and therefore Democratic politicians are careful not to screw with the structures hollywood has created to turn ordinary income into capital gains.
Given all this, the NVCA would be wise to send a crack team of accountants and lawyers to LA for the next few months with the goal of creating venture investment structures that effectively mimic the byzantine structures the entertainment industry uses to magically turn intangible assets and work product into JV/LLC/partnership equity. Should they successfully do this, the politicians will face a catch-22 and will likely be forced to call off the dogs.
It will be fun to see the game of cat and mouse plays out because with California’s marginal rates on ordinary income headed to almost 54% (including the 2011 tax hikes and the health care tax hikes), there’s clearly enough cash at stake for people to invest a lot of time and effort into beating the system.
UPDATE: I thought I would post a few more thoughts on this issue based on some comments I've gotten. First, I've written about the whole carried interest issue in the past here and here in case you are curious.
Second, I thought I would re-post a excerpt of a conversation I had with Dan Primack via e-mail a couple years ago on this topic as I think it nicely summarizes my thoughts on one of the key issues: why should entrepreneurs get carried interest and not VCs.
"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 outsized 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."
May 20, 2010 | Permalink
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