INVESTMENT
A few thoughts on the taxation of 'sweat' equity
July 17, 2007
By John Berry
The defence of tax breaks for private equity and venture capital managers generated some novel, if wrong-headed, arguments last week.
"As venture investors, we assert that it is appropriate to reward investors of 'sweat' equity with the same long-term capital gains tax benefits that investors of financial equity receive," Kate Mitchell of Scale Venture Partners told the senate finance committee at a hearing last Thursday.
"Both will only succeed if the business builds in value - so both are subject to the same entrepreneurial risk and our interests are aligned," she said.
Though the same could be said for stock options, bonuses for chief executives that are tied to stock performance, fees based on movie revenue for actors - and if we are really talking about "sweat", perhaps the hourly pay of an assembly line worker should be included.
The labour expended by those types of employees helps a business build its value. All are taxed as ordinary income - at marginal rates up to 35 percent rather than the top long-term capital gains rate of 15 percent.
The managers in question usually operate as a partnership, which in turn serves as the general partner running a private equity, or venture capital entity, on behalf of the limited partners that are investors. Typically, the general partnership puts up about 5 percent of the capital.
The general partner usually gets an annual fee for management services equal to 2 percent of assets under management. That fee is taxed as ordinary income.
Mitchell did not challenge that treatment even though presumably it sometimes involves sweat. All the fuss is about the other part of the general partner's pay known as carried interest: 20 percent of the cumulative gains realised on the equity investments. The general partner also gets the same return on its invested capital as the limited partners.
The capital gains are calculated by subtracting the cost of the asset and the cost of selling it from the sales price. But the 20 percent of the gain paid to the general partner is a management fee, and it should be taxed as labour income.
"As an economic matter, the character of carried interest income should not depend on whether the compensation is performance based," said Peter Orszag, a director of the congressional budget office.
"The key issue is whether the carried interest represents a fee for services provided or a return of partnership long-term capital gains allocated to one partner [the general partner] under conditions that are not qualitatively different from the returns allocated to the other partners [the limited partners]," Orszag said.
There is a big difference between the roles of the general partner and the limited partner in these organisations.
For instance, as Orszag said: "The carried interest is not principally based on a return to the general partner's own financial assets at risk."
The George W Bush administration's representative at the hearing, Eric Solomon, the assistant treasury secretary for tax policy, did not see it that way. Once the general partner receives the carried interest, "the fund manager becomes a partner in the fund and pays tax in the same manner as other partners" on its share, he said.
At base, the real issue is the big differential between taxation of ordinary income and capital gains - and of most dividends in recent years.
The argument for the differential has always been that it would encourage saving and investment and make the economy perform better in the long run. There is not a great deal of evidence that reducing tax rates on long-term capital gains has made much difference in saving or investment.
Most of the discussions about the differential ignore a key feature of capital gains taxation: They are not taxed until they are realised.
The late Herbert Stein, the chairman of President Richard Nixon's council of economic advisers, maintained that the right to defer tax on a capital gain until it was realised was a much more important benefit than having a lower tax rate.
With that in mind, maybe we should resurrect part of the 1986 tax reform act that eliminated the differential. That would take care of covered interest. - Bloomberg
The Straight No Chaser column will resume next week
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