Ordinary Income vs Capital Gains
I'm wandering a bit on MBA Mondays right now. I don't have a strong view of where to take this thing next. So I'm just going to post about stuff I think people should understand until I find the next vein we can mine for a while.
Today, I'd like to talk about ordinary income vs capital gains. This is not tax advice. I am not a tax lawyer or a tax accountant. I hope both tax lawyers and tax accountants show up in the comments as this is important and complicated stuff.
When you think about the various ways you can make money, two ways predominate. You can provide services to others and get paid for those services. That is ordinary income. And you can invest in something; shares of stock, a building, a domain, and then sell it later for more. That is a capital gain.
The distinction is important, at least in the US, because these two kinds of income are taxed differently. Ordinary income is taxed at the full federal, state, and local tax rates. We live in NYC and according to our accountants, we pay a marginal fully loaded tax rate of 47.62%. That means we keep about half of the ordinary income the Gotham Gal and I generate.
Capital Gains are broken down into short term (less than one year) and long term (more than one year). Short term capital gains are taxed at ordinary income rates but long term capital gains are taxed at a much lower rate. According to our accountants, we pay a fully loaded tax rate of 27.62% on long term capital gains. That means we keep about 3/4 of the long term capital gains the Gotham Gal and I generate. That's a big difference.
It gets more complicated when you have ordinary losses and capital losses because you need to understand when and how losses and gains offset each other. The rules are complicated and ever changing and I've learned to consult my tax accountants whenever stuff like this turns up.
But the important point of this post and the one I want to bring home is not all wealth producing activity is treated equally in the eyes of the government. There is a strong bias to capital gains. I agree with that bias, not surprisingly, because I think we should have an incentive to recycle capital instead of putting it under a mattress.
If you think about wealth creation in the context of ordinary income vs capital gains, you'll quickly come to the conclusion that you can build wealth a lot more quickly with capital gains than you can with ordinary income because the tax load is so much lower. This is one of the many reasons I encourage people to think of entrepreneurship as a career. If you are a founder of a startup, your founders stock will qualify for long term capital gains if you structure it correctly when you set up the company. And when you go to the pay window (to borrrow one of my favorite JLM phrases), you will be sharing a lot less with the government and keeping a lot more.
Fred, where do you come down on the question of carried interest being treated as capital gain income? I think it’s critical that the person receiving the preferred tax treatment on capital gain actually have their capital at risk.
i agree with you Paulhttp://www.avc.com/a_vc/201…
The “carried interest” earned by a sponsor of any investment held in a partnership is the value of expertise and experience invested in the partnership. This expertise and experience may be THE critical element in the success of the partnership and sponsors need to stop being embarrassed by this fact.The most basic tax concept of partnerships — this is the IRS’ view, not mine — is that of financial partners and service partners. Even the IRS recognizes that partnership ownership is earned by service alone.The partnership owns the asset and it is the value of asset (not the partnership) which creates the wealth — not the capital accounts of the partnership. Not the “security” of the paper ownership of a partnership interest.You are going to drag that asset to the Pay Window — not your partnership ownership, the asset itself. The asset determines the appropriate tax treatment of the gain not the manner in which it is owned.The value of the asset over the holding period is what gives rise to the profit and the profit is what is characterized as ordinary income or capital gain.How one received their interest in this profit is irrelevant to the characterization of the profit.On a pragmatic note: shrewd sponsors need to start focusing on the investment of a promissory note to earn the characterization of the profit as a long term capital gain.
Short term capital gains means you kept the asset for less then 12 months correct?
generally speaking, yes
Half of what you earn is taxed means it is not taxing it is looting…
I don’t think people would mind the tax as much if they saw it going to action. I moved to Sweden about 2 years ago where the rates can reach 55%. People aren’t so angry because they can see the value added. Back in the states we get taxed but no free education or healthcare. You should see the parental leave here, its nuts. The capital is recycled back into the society.
I agree with you when I see my tax is being used and put to action for welfare of the people (including me). I am all for it when it serves the society and against it when it serves only a group of politicians and thereof. (worst in the country where i live..India).Yes. I totally agree with you and how it works many of the European countries set up … free health and education … it is great.
I am an American citizen…and trust me the system doesn’t give much back as well.However our focus on capitalism is what excels us in some fields such as tech. One thing that is disappointing is to see the spread of wealth between the segments in society. I am sure you experience that as well in India.
BTW, if you have not seen the latest Ayn Rand movie, you should. Very accurate to the book though set in 2016. Damn looters!
Rand was a nut job.
Well, OK, but it’s still a good yarn. Matt Damon is a political neophyte but he is still a good actor.
I feel like no 10 million dollar production can capture the quality of that book accurately. But I’ll have to see it soon
It’s actually only the first 1/3 of the book and it was an entertaining movie made all the more so by being such an accurate depiction of the book. Dagny is a knockout.You have to read the book and remember it to really appreciate the movie.I loved it.I just hope they are able to make the other 2/3s.
Barely remembered the book, I think I read a synopsis in high school (half my life ago), and yet LOVED the movie.In keeping with my optimistic nature, I kept thinking to myself…we don’t have to go there.So many Americans are still dreamers, builders and producers. We can turn this ship around.I’ll cling to that belief until my dying day because this country and its ideals are worth fighting for!
No to get all emoticon on you, even the ability to finally get OBL shows what America is capable of.As it relates to our current state, we are our own worst enemies.In 5 years, this will all be like an Alzheimer’s memory.
So true!And as for the other 2/3rds, I think they’ll get made. Many people commented that box office was low for Part 1, but it opened on a small number of screens. The revenue per screen number was quite respectable.
It was surprisingly good for the low budget. A must-see film.
Now that you mention it, if that was indeed a $10MM film then it was quite extraordinary given the huge sets and effects. I loved the movie and in a very weird way it is perfectly applicable to today, isn’t it?
Extraordinarily applicable to today.I can usually tell instantly when a movie was made with digital video instead of film…the depth of the photography is usually very flat.Mind you, I wasn’t looking for it, but it was about halfway through the movie in an outdoor shot that I went “whoa…this isn’t film? Darned good job.”
I will.Every year there are 10’s of movies produced on this subject in our country … but what we have is the option to choose between “looters” and “lootest”.It is just like the old saying goes “jumping from frying pan into the fire”.
Same day sale of employee stock options should not be treated as short term cap gains (and taxed as regular income). I was always a same day sale guy when I was at YHOO (and it was the right thing to do in 1998-99). Employees who are awarded options are a different case than a trader who buys an option. The employee takes career risk and has a contribution to the increase in value.
i totally agree. ISOs help but this is a huge issue
Erik, respectfully disagree with your position. Options are offered as an inducement to accept a particular job and are in addition to (and frequently in lieu of) cash compensation. The key here (as you put it well) is “career risk” versus capital risk. Persons who are compensated for service should be taxed as ordinary income.Like my earlier comment that the preferred treatment of cap gains should require the commitment of actual financial capital, so too it should be for persons who accept employment. Besides, if a start-up company wanted to offer equity to persons when the equity was of little or no value, it is possible to do that as well, and through Sec 83(b) the employee can make an election to be taxed as capital gain upon sale.
By taking a lower salary I am investing actual real financial capital. Actual financial capital that I cannot take a deduction for if I lose it (unlike cash investor). Actual financial capital that the company can use to hire other people. If I take a $100K salary cut to go to a start up and the start up tanks I can’t write off the $400,000 ($100K X 4 years of vesting) actual financial loss I took.A traditional investor can use that loss to offset other capital gains.
people seriously overestimate career risk, especially early on in one’s career, because a lot of this community is networked into larger corporations (for example) as well as others doing the same thing….
Stock options should be treated as an “original issue” security — the stock option itself is the security not the share of stock into which it is converted.The time period for tax purposes should be the issue date of the option not the receipt date of the shares.
Doesn’t “marginal tax rate” mean in principle that you pay that tax only on the last additional dollar of your income? In that case, it does not mean that you pay about half your income in tax; it only means that you pay 47% on some part of your income. The lower brackets are taxed at a lower rate. At least that is how it works here in Germany…Of course, if you consider the part of your income in the lower brackets to be negligible in relation to the part in the last bracket, then the statement “I pay half of my income in taxes” is correct.
For Fred to pay in the highest marginal tax rate, his taxable income (for 2011) would have to be above $379,150. Yes, you are correct, only his income above that threshold is taxed at the highest marginal rate. That figure is arrived at only after subtracting whatever deductions from income he has already taken. In the U.S., significant deductions are available for mortgage interest, charitable contributions, and contributions to qualified retirement plans. Of course, I have no idea what Fred does in these regards, so I do not know how much “gross income” he would need to earn before he pays the highest rate. Note also, there are different tables for NY State and NY City, of which he is a resident and pays state and local income tax.
correct. i don’t feel comfortable sharing the details but i do pay quite a bit of taxes at the marginal rate
Fair enough (this is not a referendum on your income or taxes). And I am sure there were years in your life where you paid absolutely nowhere near the highest marginal rate. It baffles me that so many people (probably not as many in this community) fail to grasp the concept of marginal tax rates. At $379k per year, I would venture that puts you solidly in the top 2-3% of all households in the U.S., but probably not in as high a percentile of your end of Manhattan. 😉 What is interesting is that while we have had progressive taxation on ordinary income almost since the day the income tax started, we have never adopted such progressive treatment of rates on capital gains.
We do not have a “progressive” tax system, we have an “oppressive” tax system.The top 10% pays 70% of all taxes.The bottom 50% pays 2.7% of all taxes.
That might be fair if the top 10% of people has 70% of all the money and the bottom 50% has 2.7% of all the money.I don’t know if that’s how it breaks down.
The tax is not on “money”, it is on income. The top 70% clearly does not have 70% of the income or otherwise the tax code would not be progressive.
That’s a really “interesting” way to dismiss the reasons for progressive tax system.Why do you think the bottom 50% pays that little? That’s not really a hard question, btw.
I am not a huge opponent but I am a fan of fairness even in progressivity.When the top 10% are facing nominal rates — Fed, State, City, payroll — which exceed 50% of a man’s labor I need no further information to know that is way, way, way too high.When the bottom 50% is facing rates approaching 0%, I need no further information to know that is way, way, way too low.The current economic dilemma we face is not that taxes are too low.When a man’s labor belongs to the State, that is a penal colony, a tenant farmer — we are not a nation of vassals and our government should not treat us as such.When you add up income (Fed, State, City) taxes, payroll taxes, property taxes, sales taxes, gasoline taxes, excise taxes…………….and then add fees on top of that.We are pawns of the State and I am ready to call it what it is — slavery.
You didn’t answer my question.The reason the bottom 50% is paying that little is because the income inequality in this country is getting out of hand. The poor don’t pay taxes, because they don’t earn anything.You can rant all you want about oppressive taxation, but that’s NOTHING compared to the way the working poor is getting exploited for the benefit of shareholders.You mentioning slavery would be kinda ironic in this context, if it wasn’t so incredibly offensive. You really feel like a slave? Give me a f***ing break! Tell that to someone working two full-time jobs to support their family, because one job is not paying enough to buy food, just so that the shareholders can get even richer.Your perspective is so ridiculous I can’t even fathom it.
Long term capital gains is the main reason why our tax system is arguably regressive. As you climb above $500,000/year, the next dollar is far more likely to have come from LT cap gains than salary.It may appear that 370k is the highest bracket, but we actually have another soft bracket with a LOWER tax rate.I’m all for the tax code favoring certain career choices (e.g., entrepreneurship), but the current targeting criteria is really quite poor.
Yes, but you live in NYC. Now, if you lived in the nice hills outside of Knoxpatch in east Tennessee, then there could be some big advantages. Indeed, not far away is a city with 1 GbE, which is world class.
I’d like to introduce a yiddish phrase here:”As di bubbe volt gehat beytsim volt zi gevain mayn zaidah.” …which translates to “If my grandmother had balls, she’d be my grandfather.”
@sigmaalgebra:disqus are you in East TN? If so, I’d love to connect. I’m in Knoxville.
It’s gotta be wild to see the world through investors eyes. I’ll keep the huge tax incentive in mind but I’m already sold on startups. It may take a circuitous strange journey to lock and load into one.No shame in the pay window, just gotta weigh it with the conditional probability of an exit if you’re a hire vs a founder. Founders are all in until an irresistible opportunity to take money off the table crops up.
The economics reason for having a lower capital gain tax is that one can avoid capital gains ENTIRELY by not selling the capital.One could just start companies (some with next to no capital) and not sell them and pay zero capital gains.But if one does not sell companies, the government obviously gets zero capital gains tax revenue, and one can’t move on other new companies.
is that right? if you never sell, how do you get the value of that wealth creation?
Borrow against it and then die with insurance in place to pay off the debt. Give your heirs the asset at the stepped up basis — current market value.
ah yes. i think you should be writing these mba mondays JLM
It works well now! You pitch. He takes a swing, breaks the ball into 10 pieces, and, one by one before any hit the ground, knocks it out of the park!Net, some of the best ‘business’ content on the Internet. When I was an MBA prof, I wish I’d had so much good content.There are important lessons here for the future of content and the Internet.
yup. so true. and this whole thing is an accident
So then your “tax” is the insurance premium plus the interest you must pay to borrow against something that you own.(I say “tax” in quotes, because it’s a financial penalty, although it doesn’t go directly to the government.)
Yes but you beat the tax man during your lifetime and the stepped up basis beats him when you die.An elegant solution but one that is totally unnecessary if we had a rational tax system.Now we have the dumbest system ever —Earn the money as ordinary income and get taxed.Invest the after tax earned income and make a capital gain and get taxed.Die and get taxed.Tax the damn money only once.
Where’s George Harrison when you need him?Sorry, still stuck on the music biz analogies.
“Give your heirs the asset at the stepped up basis — current market value. “I’m no expert in such tax matters, and you lost me: The heirs have to pay inheritance tax on the (high?) “stepped up basis”? That inheritance tax could force them to sell the assets just to pay the inheritance taxes? When they sell, due to the “stepped up basis” to “current market value” they have no “gains”, capital or otherwise, so have no taxes to pay on the gains. But due to the inheritance tax, the gumment stands to do well?
Sig, I can only solve one tax problem at a time. First, it is the owner’s ordinary income tax issues and then the heirs income tax issues.Estate taxes are a whole ‘nother issue and one that CAN be overcome but I am too lazy to lay it out just now.But consider, the estate should have a comprehensive strategy of gifting, slipping under the estate tax threshold, generation skipping, trust formation, insurance to pay tax liability and borrowing against the stepped up basis.It takes a bit of work but it CAN be done.
So, there’s a lot to the planning of the combination of both business and taxes, especially over time, more so under uncertainty.I don’t want to trivialize any of this, but it does appear that there is an old ‘technique’ that should not be neglected.The technique is for quite general situations of ‘decision making over time under uncertainty’. The technique can be crucial when there is a lot of uncertainty (assuming we have a description of the uncertainty) but can also be useful when assuming no uncertainty can be a close enough approximation.It’s not clear how old the technique is, but it was enhanced and popularized by R. Bellman, especially in his ‘Dynamic Programming’ of 1957.At this point the relevant literature in both books and research papers is enormous.Notable is the writing of S. Dreyfus, e.g., as inStuart E. Dreyfus and Averill M. Law, ‘The Art and Theory of Dynamic Programming’, ISBN 0-12-221860-4, Academic Press, New York, 1977.At its core, dynamic programming (DP) is a simple idea.In comparison with other techniques, DP does relatively well with various discrete situations, non-linear relationships, and uncertainty.The main area of applications is deciding what to do — i.e., ‘programming’ — over time. The ‘dynamic’ part is that the technique recognizes and appropriately handles the important point that over time we discover new information and then exploit it to change the ‘programming’. And even if there is no uncertainty so that we don’t discover any new information, at times the technique can yield important improvements computationally.A simple example would be the ‘option’ play in football: When the ball is snapped, just where the fullback with the ball will go is not yet determined. Instead, if the linebacker goes inside, then the fullback goes outside, etc. So, what the fullback does depends on what the linebacker does and is discovered after the ball is snapped and during the play.The main difficulties in making applications DP are (1) situations with too many dimensions that encounter the “curse of dimensionality” and, thus, make needed computing unreasonably large, (2) the need for knowledge of too many fine details, and (3) getting sufficiently good descriptions of relevant uncertainty.Still, at times, on selected problems, DP can work very well in practice.Wikipedia has a lot on DP, and a Google search can show that the promising role of DP for financial planning, in practice, has been noticed and pursued.Here is the main, simple idea in the main case: Suppose you want to do personal financial planning for, say, 40 years, assess your situation and make decisions once a month, and want to end up with the largest expected ‘net worth’ you can.So, inputs include details on taxes, insurance, mutual funds, your business, scenarios for interest rates and inflation, etc.Each month there is your ‘state’ which characterizes your situation well enough that data before that month adds no more information that is relevant (we’re satisfying a Markov assumption, and this subject is also called Markov decision theory).So, we go the end of the ‘horizon’ of 40 years and have a computer enumerate all the states we might be able to be in then and the ‘net worth’ we care about for each.Then we step back (toward the present) one month, and again enumerate all the states we might be in. For each such state, we consider all the decisions we might make at that state and evaluate that decision. We do the evaluation by applying the scenarios for the uncertainties. For each scenario possibility, we see where we ‘land’ at the next month and what net worth we get. We average these net worth values over the scenarios. Then we pick the decision that gives the highest average net worth. We rinse and repeat for all the possible states. Yes, if we have 1 million states and 1 million processors, then we can do the evaluation for this whole month using all million processors — in general, DP can make excellent use of parallel hardware.Then we step back another month and repeat.Each month is called one ‘stage’.Here’s where the big gains happen: At each month (stage), we need look forward only to what we evaluated and tabulated for the next stage. So, at month 100, we need consider only what we found for month 101. Then for month 99, we need consider only what we found for month 100. Etc.Basically DP works well when there are many possible decisions and stages but not so many states at each stage. The gains are from decomposing the whole problem to just a sequence of problems, one for each stage.So, we are iterating backwards in time: We start at the end, in the future, and iterate back to the present.When we get back to the present, we see what decisions to make now.Our work does not tell us our net worth at the end but only our expected net worth. Our work makes that expected value as large as possible.Due to the ‘dynamic’ part, we do not know now just what decisions we will be making over time because, just as in the football option play, those decisions will depend on how uncertain events occur between now and then. This ‘dynamic’ part is crucial for the best possible decision making making best possible use of all the information available when each decision is made. This technique gets the largest expected net worth in quite general terms and, thus, is what we want.So, for the ‘answer’, what to do, that is a ‘decision table’ for each month: To use a table, we note our state at that month and read off the decisions to make and also see our expected net worth at the end.So, for an ‘answer’, we get, for each stage, a table of decisions in terms of state at that stage.If our input includes a lot of detail on taxes and various possible financial actions, then it may be that the decisions that get made will look astoundingly clever, perceptive, tricky, prescient, brilliant, diabolical, etc. Adjectives aside, the technique just maximizes that expected net worth at the end.So, this technique has a shot at working IF can get the needed inputs and IF the number of states at each stage can be kept down to, say, 10**n for n of maybe 7 or 8 but not 15 or 20.Much more is known and can be done, but for the more advanced details ‘ease of use’ goes out the window.Generally, each step forward on processors with many cores available via the cloud will make it possible to use DP to solve a new and possibly valuable collection of practical problems.Yes, this is a direction for ‘information technology’ that is based on some applied math and not on the ‘social graph’ or, really, even ‘computer science’.
OK, I get what you are saying but it is a bit too big a thought. The base case is — can you get your wealth out of the hands of the gov’t? This is the fundamental challenge.As to the option, the full back always “dives” straight ahead whether he gets the ball or not, the QB decides whether to hand off or “belly” the ball and take off running. The beauty of this play is that the middle LB always has to “spy” on the fullback unless he is willing to gamble that the FB is not getting the ball.It is this arithmetic matchup which provides the numerical advantage for the offense at the point of attack and which tilts the probabilities toward the short guys from the AFA.The flip on the option is the biggest risk.
This is what makes accountants, lawyers, and finance guys work on schemes which are totally outside their original value add.Don’t get me wrong there is a value add here but it only is to avoid taxes.People don’t realize the cost. It bastardizes the whole system. Instead of counting beans, papering deals, and financing companies for the purpose of growth you focus on ideas which add no value.You and I disagree a bit on inheritance tax because I think that in a perverse way if you don’t see you parents working because you are either too rich OR too poor you are permanently screwed.Therefore, it should be tax free to give each of your kids enough money so they never have to work and therefore screw up your grandkids, but I’m not sure somebody like Bill Gates should be able to buy up the entire state of Washington and make his own fiefdom in the U.S. (which he could)In both cases the sad part is that the “regular” working rich are the ones that get screwed. The people like the Dupont’s will always be able to pass along as much money as they want.
The value of the wealth creation should be the present value of the future income.If you don’t sell, you just collect the income every year.Of course you or any buyer will pay income tax on the income, but there is not capital gains taxes since there was no sale.If capital gains taxes were high enough, 50 percent or more, people might start trying as JML suggests, to free up money by borrowing instead of selling. I am not sure about the inheritance tax angle.
Good tax advice. JLM makes a good start on it below. But there’s more…much more…
Peter grows up in a middle class family, works hard in school, gets accepted to a decent college, and graduates with 20k in school debt. He manages to find a job that pays 100k a year right out of college because he worked so hard in school. He pays 28% of this income in taxes. If he keeps working hard, he can continue to see his income taxes go up.Peter’s friend Richard grows up in a wealthy family and is given a $1M gift upon graduating from high school. He spends his time playing video games while his family’s wealth manager grows that money for him, at around 10% a year. Richard pays taxes of 28% on this income. Even if the wealth manager continues to do well, Richard will keep paying that same tax rate.I understand the need to incentivize capital growth, but the idea that this is the reason for the tax disparity is only one feasible explanation. Another, much simpler explanation, is that the people who write the tax laws make most of their money from capital gains.
or peter can start a company and become wealthy and keep most of the gains because of the preferential treatment of cap gains
Oh, that’s all he has to do?
Richard’s Father worked his ass off for 40 years to create wealth. He accumulated a meaningful estate — having paid taxes on it every step of the way.He wants Richard to become a studio artist and knows that Richard will never be able to make a buck as a studio artist.So Richard’s Father breathes life into Richard’s dreams and endows Richard’s lifestyle with the hard work and diligence he employed his entire life.Richard’s Father gives to his son the hardwork of his lifetime.Why the hell is anyone feeling like Richard or his Father should be punished for the Father’s hard work and generosity?Income should only be taxed once and folks should be able to do whatever the hell they want with their money.
Considering that if he is successful he could make serious money, plus teaching opportunities
The scenario you describe is just an anecdote. The only people who put their money in a fund and CONSISTENTLY get 10% returns as you’ve suggested are the people who invest with Bernie Maddoff. We know how well that turned out.In any event, our tax code favoring investment income encourages people to invest rather than consume their capital. The $1mm invested by the trust fund baby goes to companies that need it to drive growth, such as paying for salaries of other workers. It’s about positive outcomes, not personal or political values.Many economists argue that lower capital gains taxes than we have now (like 0%) would be better for all.
Not to piss on the campfire but your taxes on ordinary income are actually quite a bit higher as you have apparently failed to include payroll taxes.When America was formed springing from the angst associated with a 0.5% tax on tea and the frustration of being taxed by a King and Parliament in which the Colonies — English subjects all — had no representation, do you think the Founding Fathers ever conceived a system in which you would be a vassal of the State?You work for the State and pay more than half of your labor to perpetuate a system which does not really care what you think about anything.Intellectually we are a slave colony when it comes to taxes.
good point. i did say that about half was going to taxes
Capital — one’s residual wealth after having paid taxes on it at least once — should NOT be taxed at all. It is “after tax” dollars.How many times should income be taxed?The US is at a competitive disadvantage worldwide when it comes to the treatment of capital gains and it shows up in many ways. I suspect there is a 5% shadow tax created by the necessity to employ tax analysts, tax accountants and tax lawyers.Michael Dell goes out and starts a company and employs 50,000 people — all of whom pay taxes for the rest of their lives. Who gives a crap if MD ever pays taxes?The net gain to the Treasury is enormous. Why not be happy w/ that outcome?You want to create jobs in America, then someone is going to have to be able to make a buck in the process.It is time to stop punishing success, if you really want to create jobs.
Unfortunately, the politics of Envy get played and the lazy love it. In the bigger picture, we need to push raising the GDP via the production of everyone. Then the number of those that either hire themselves (entrepreneurs) creating small businesses and/or those that develop tools that allow people to do more creates a bigger pool.Sounds wishy washy, but at this time, all we have is the same arguments with the sound horns being those that have not a clue what they’ve just said.We grow this damn thing and ignore the politicians, then we can back ’em in the corner and be ready to strike when they come up with their next overblown piece of crap to maintain their power.Hell, we’re not a full day forward finding out OBL is toast and the predictable BS is emanating from both sides.
“I think we should have an incentive to recycle capital instead of putting it under a mattress.”The money that most people “put under a mattress” is post income tax, making it a bad comparison. And they don’t put it under a mattress, but in a bank. A bank actually does invest that cash. Are people better at investing than a bank? Can they absorb the same risk at their absolute savings levels? No on both, depending.You might be able to make an argument that normal people should do more investing, but the alternative is consumption. People choose to spend money on consumption instead of saving at all — whether that saving is through a bank or in a friend’s business. A lot more would need to change in our culture for that to become more common.The levers government has in our tax system are quite weak here. In fact, they are worse than nothing because they give the appearance of control where there is none.For example, I work at a startup now where I get paid a mix of cash and stock. What if I wanted the balance to be more stock? I’d start another company. The last thing on my mind in making this decision is marginal tax rates. This makes me surprised to see this argument that our tax system incentivizes investment. It rewards it, but it doesn’t sway decisions because those decisions don’t happen in a vacuum.
Most of the small business in US are pass thro entities so they pay ordinary income tax rates and also they reinvest the money back into business. They are inherently non-scalable business so the owners don’t realize wealth by selling the business instead they get it thro the profits from operating the business… IMO, its not ethical that his tax rate is double than that of a tech entrepreneur or a wall street hedge fund guy.My personal preference would be a lower overall rate (25%) with no deductions for both ordinary income and capital gain. For a brief time in US history (in the Reagan administration) this was the case and from what i read it never discouraged capital investment/capital recycling.
This is the perfect post to remind that the US tax code should favor SMB owners over all other forms of investors.A SMB owner is an investor, the very best kind of investor (they invest in themselves); the “income” that passes through to them should be considered investment income as long as they reinvest in any other SMB they choose.The rate for this should be zero – effectively gaining top dog status currently held by the 1031 rule with real estate.If we really want to be specific, we should put an age limit on SMBs to encourage newco formation.With this new hierarchy in place, all other tax code should be written.
I agree more with you than you do with yourself.A SMB owner should get a job creation and maintenance tax credit and should pay no taxes on any business sold after 20 years of operations.You want jobs? This would create jobs.
Yeah, I’m thinking to get there the Tea Party needs to start talking about the difference between good and bad rich… which I’m sure Fred might not like.It is a tough issue, because you hate to create a phrase “bad rich” but at the same time, we absolutely need to raise the SMB owner up as the pinnacle of human achievement… and that means demoting everyone else a tad.Being a mere investor is nice, but its not as big a deal to us socially.This change in our approach will even out the brain flow of talent between Wall Street and actual hands on job creation.
The challenge for small business is that they never can really afford a great lobbyist and they never get a seat at the table. Everybody pays them lip service but nobody really invites them to the dance and they are all so damn busy they can’t come any way.Riches are only the basis for being able to do good works. Obvious good works and underground good works. This is the yardstick to hold up to wealth.OK, so what the hell did you do with it?The sense of accomplishment that one gets by starting, running, growing and operating a business and taking care of one’s employees is a psychic currency which accrues to the wealth of your soul, your inner person.There are timid — but wildly successful — souls who will NEVER know the fulfillment that such a journey brings.If you want to drive job creation in this country, then you are going to have to make it rewarding to be a small business owner as that is where the fertile fields lie for the sprouting of new jobs.
As I said to Jeffrey Immelt, who scoffed at me when I was on Senator Carpers roundtable.If I could take a direct credit for my SocialSecurity and Medicare match, along with a credit for the health insurance premiums and 401k matching, I would be happy with all of the current tax rates.My effective rate would be zero and I wouldn’t have a tax department of 800 and have to hire tons of former IRS heads.
The IRC is a self perpetuating full employment racket made only worse by the army of lobbyists, politicians on the make and special interest elements.
The amount of talent squandered in playing the tax game is obscene and the productivity lost is beyond belief.
When you say age limit, do you mean age as in the longevity of the company or age as in the birthdate of the founder(s)? I assume the former…
the first one – research indicates job growth nationally comes from a class of newcos that go big – if they haven’t gone big in some period of years, the chance of it happening is very small.
Re JLM, I’d just like to point out: http://www.quora.com/Who-is… 🙂
they’d be better off asking that question here
yeah, cross posting questions from quora is important – is there a way to help both disqus and quora?
He is nobody and he is everybody. He is but a wanderer and a lost soul.He is a multi-tasking blowhard who can type very, very fast. And has an opinion on just about everything.For a BBQ and a beer, I will out the son of a bitch.But you will have to come to Austin, TX to pay up.
Next SXSW then. I hear it gets too hot after 🙂
As William Tecumseh Sherman said about the weather: “If I owned Hell and Texas, I would live in Hell and rent out Texas.”Everybody needs an excuse to come to Austin and a lot of them never leave.
Fair enough. As a long time AVC lurker, newly-moved-from-Dallas-to-Austin guy and admirer of your comments for a while, here’s an open invite. Let me know of a good way to reach you, and we’ll catch up for BBQ and beer or two. Whether it’s the wood tables of Franklin’s or the decidedly fancier Lambert’s is your call.
Text to local area code 656-1383. I am out most of this week but we can meet whenever we are both in town.Last week, Harry DeMott, an AVC regular, and I had a delightful chat and a few drinks downtown where he was opening a new movie theatre he had invested in. Harry was staying at the very, very upscale W.I had to send him a modest tuition check for all that I learned from him.
Will do. And I’m looking forward to checking out the new theater as I’m temporarily housed a few floors above it. Safe travels.
two of my favorite people. wish i was there
no fair. i may outlaw discussing bbq and beer in these comments
asked on quora, answered on avclove it!!!
its true that long term capital gain is best to avoid taxes…….
You shd set up in India, long term capital gains tax is zero.
This statement alone shows the long term futility of taxing capital gains. India is a brilliant country filled with hardworking, well educated and intelligent workers.This is why everybody is outsourcing everything to India.They have more fundamental respect for small business and entrepreneurial rigor than the US which once upon a time owned this franchise.I am long, long, long India.
All those Indians coming here — including, just here in the New York area, Hindus littering in Jamaica Bay and Sikhs starting sword fights in Queens (you can find a video clip of that online) — must be unaware of how low Indian taxes are. Or maybe they are aware, and realize that you get what you pay for in India: shabby infrastructure, poor sanitation, sparse public services, etc.Look, I think taxes here should be lower and flatter, but engaging in a global race to the bottom — in taxes or wages — is a bad idea. The countries with the highest quality of life for their citizens often have relatively high taxes and high wages (think of The Netherlands: how many Dutchmen would move to India for a tax break?).
Knowing my attraction to dueling as an alternative dispute resolution technique, do you think I wouldn’t love a couple of Sikhs dueling?
It was a brawl, not a duel.
OK, so there was more than one dispute being resolved! But I just like the idea of it.
Philosophy is always debated at the extremes while real life is always lived in the middle.
If that we’re true, you’d be splitting your time between the U.S. and India.
Dave, I live in Texas which just happens to have “merged” with the US. A merger of equals in which Texas let them keep the name.On Earth as it is in Texas!Real life is lived in Texas. If I never had to leave Texas, Austin, my house, my swimming pool — well, hell, I’d be happier than a pig in shit!
Have you ever been to India? No offense to my many Indian friends but it is a sh++hole. They’ve got much, much work to do on their infrastructure and improving the lives of the majority of their citizens.
Yes, back in my Kipling days I walked some “hills” and visited some hill stations tracing some of his poetry and stories.I guess it reminds me of Newark, NJ with no apologies to my Newark friends because I don’t have any but spent a lot of time there dealing w/ insurance companies. Now that is a shit hole.
As a long time reader and my first post to the community, it is glad to note your observations on India, JLM.We have had very limited exposure and opportunity (post liberalization- 1991) and in that short span we seem to have done not too bad.One other thing that that you mentioned that plays am important role is the importance and the role of education.A few of us have been to fortunate to be educated in some great graduate schools in America (I went to Ohio State for my MS) and have lived through the exciting times of the .com era in late 90s and early 2000’s.With many of us moving back to India with valuable experience from the US, entrepreneurship is just getting started and we have had few successful examples of first generation entrepreneurs, where traditionally new businesses of scale were earlier the domain of a few families.Most others have transitioned into great jobs in Cisco,Amazon, Ebay,Yahoo,Google, MSFT, HP,IBM in India.As you have rightly mentioned, small businesses in India tend to be entrepreneurial themselves more out of system constraints and design than by choice.Preservation of capital, value for money etc. are driven by necessity and awareness and the scarcity of it.As critiques have pointed out here, we do have a lot if infrastructure constraints and barriers, but this is being viewed now as an opportunity rather than a barrier(Look at the number of infrastructure PE funds in India and funded compaines)
You are absolutely correct, infrastructure is not a problem, it is an opportunity. I have a considerable amount of money invested in India. It is a huge bet on the country itself. Best wishes to you and your great nation.
Glad to hear that. I have been involved in infrastructure consulting on the energy side in considerable sized projects in the Southern part of the country and more recently in clean energy opportunities advising fund and investors from Europe and the US. Do you ever travel here to visit your investee companies/funds?
I wish someone would do a good post about corporate account expenses and tax deductions. Through my professional experience it was very surprising to see how many people didn’t truly understand it.
One executive works (uses his labor, not his capital) and is paid a salary of $250,00)/yr., which is taxed as ordinary income (in the upper 40% range, in Fred’s example, fully loaded).Another executive works (uses his labor, not his capital) and is paid a salary of $1/yr., plus stock or options that vest over time and which, when sold (or exercised and sold in the case o foptions), result in $250,000 of income (or even a bit more, to account for the delayed benefit). That income is taxed as capital gains (even though there was no capital invested), in the mid-to-upper 20% range (in Fred’s example, fully loaded).How is that fair to the first executive (or to the average worker, who can’t cut the same deal with his/her employer to take advantage of this tax loophole)?
Because the 2nd exec gets nothing if the stock has not appreciated since the options were awarded.If the CEO takes a job for $1 a year and 100,000 options with a strike price of $10, if the stock is at $8 when those options vest then the CEO’s total compensation is $1. If the CEO is awarded actual stock (not options) he/she is taxed on the fair market value at the date of the grant even if the stock is illiquid.
and – your point is?Your talking about a completely imaginary situation. This never happens. Everyone knows the CEO will pump the stock price up before they cash out. Besides, they get their buddies to make them a member of their board with a not to shabby salary. That’s probably tax exempt too. Who the hell knows anymore.
This happens all the time. If you’re on the $1 (+ options awarded on Jan 1 vesting in 12 months) a year plan and the company loses value during that year (say YHOO 2007, or GOOG 2008) the exec LOSES money if they choose to sell).
“Because the 2nd exec gets nothing if the stock has not appreciated since the options were awarded.”There are two problems with the risk deserves a tax break argument. First while risky behavior is necessary with an impossible to predict economy, there is no need to subsidize risk. If anything, people are overly optimistic about their future and take excessive risks without any subsidy.Second, from a noneconomic, moralistic point of view many other people take more risks than CEO take. Knocking on doors in Pakistan is more risky.There are other arguments for capital gains taxes (people don’t sell if the rate is high) being treated differently from income taxes (most have to work) and the problem drawing the fine line between capital gains and ordinary income.
I actually disagree with this – we don’t need to subsidize excessive risk, but if we don’t subsidize some risk, we won’t see the potential gains from that risk. Most people need a push to take any sort of significant risk, but behavior economics suggests that we try hedging our risk a little too much if we don’t feel comfortable that we can survive said risk.
I don’t think Bill Gates and Paul Allen even looked at the tax rates before starting Microsoft (I have not read Paul Allen’s recent book). There were hundreds if not thousands of similar small firms doing the same thing Gates and Allen did, the vast majority of which did not live up to hopes.
I’m thinking more for the situation of serial founders
I would guess that you are referring to “behavioral” economics experiments where one tells people to choose between a 100% sure $100,000 career and one that has a 50% chance of paying $90,000 and a 50% chance of paying $115,000 everything else being equal.Because of risk aversion and decreasing marginal utility of income, many people will choose the sure $100,000 over the higher but uncertain expected value. (with no insurance market)But in real life, they don’t tell you have a 50% chance of being a success. Just ask Fred Wilson and his past “successes.”In real life, the vast majority of people overestimate their own chance of success and many other things. This also applies outside economics; both sides in the Civil War expected an easy victory. It’s always the other people who will end up in a nasty divorce not us (until you are 50).So people think they are going to be the high-paid lawyers when they start law-school, but many end up being paid less than teachers. There is no need to subsidize risky careers, since if anything, over-optimistic people oversupply themselves.Many of these high-risk careers are “contest” models.
Agreed that in part this is a “contest” model. I just don’t think this is a winner take all contest, and that we can make policies and environments to cause much higher overall success rate.
There is no “fair” in life, except for Dallas in September.Not good but true.
or NYC in Maywhich it is right now!!!!!!!
The UK has an ultra-low rate of capital gains tax on the first million pounds an entrepreneur makes [from selling her business]: http://www.hmrc.gov.uk/cgt/…
Or you can move the domicile of your company to the Channel Islands the day before the closing…………………and pay nothing.
The treatment of capital gains seems to me to be one of the core financial benefits of founding a startup, particularly in a space like software. When bootstrapping a startup and consulting on the side (or some similar activity) to generate income to finance those efforts, from a tax standpoint, the founder is effectively getting to make tax-deductible investments.Money spent on designers, developers, contractors, etc. is treated as an expense, offsetting any ordinary income the founder may be generating elsewhere. If the startup costs are in turn actually creating a valuable asset, from the perspective of the founder, those costs are really an investment in an asset. Should the founder sell that asset down the road for a gain, he or she has effectively shifted ordinary income to capital gains. In a business like software, there are an awful lot of what I would consider capital expenditures early on that are treated like expenses for taxes. Sort of like a 25% side benefit (using your figures) for being entrepreneurial.
Totally disagree – all money should be taxed the same – and all forms of inheritance should disappear. Only then can nature take its course.
Fred, I like the MBA Mondays posts on your blog. You mentioned that you are considering where to take the series next…I found that some of the most valuable things I learned in business school were not the finance issues, but the people leadership and management principles. I’d love to see you share some of those areas with your readers.Perhaps a post on negotiating techniques? Or the importance of corporate culture?(For anyone interested, one of my favorite b-school professors has a lecture he did on youtube where he talks about the importance of self-awareness for leaders: http://www.youtube.com/watc…
Negotiating would be an excellent topic, but maybe Fred doesn’t want to let entrepreneurs in on his negotiating tactics.
i don’t like to negotiate. most of the time, i’ll make my best and finaloffer right upfront. it worked with twitter. we did that deal in about fiveminutes.
interesting… 5 minutes wow! I guess each party was fully aware of what they were looking for, and wasted no time.
@fredwilson:disqus @168eabd0f099d310caf76736f858376a:disqus Most people don’t like to negotiate. It almost sounds like a dirty word sometimes.Maybe that’s because a lot of times negotiations fixate on the zero-sum aspects like price, salary or valuation. In those cases, every win for one side comes out of the other side’s pocket.In negotiating class they often teach of concepts such as expanding the number of deal points to make more room for outcomes that satisfy both parties. In a term sheet, its the many pages of other terms. In hiring, it is the vacation time, title, benefits, start date, etc.Another interesting aspect of negotiation is the question of which party makes the first offer. I’ve seen a lot of people struggle over whether they should make an offer or wait for the other side to make the first offer. People consider it a matter of personal preference. But business schools teach that it is almost always better to make the first offer unless you have substantially less information than the other party. (http://hbswk.hbs.edu/archiv…I think a post on negotiation would help level the playing field for entrepreneurs. The big companies and VCs they often negotiate with sometimes have much more experience in deal making.
i can try to write about this stuffremember that i’ve never managed more than a few employees
In Europe (at least in Czech Republic) if you sell share in the company owned for longer than 5 years it is not taxed at all 🙂
Very true and pretty interesting taxation system we have. The tax law is basically structured to make people behave certain ways. Like you pointed out, it gives us a reason to recycle capital (the lower capital gains rates). One point to mention (a technical point) is that there are some recapture rules on assets used in your business. When sold, a portion of that gain is treated as ordinary income and the remaining portion as long term capital gain. Strictly from a business side and not personal side which I think you were focusing on.
A tad political:Should there be such a disparity (20%) in the different tax rates? Wouldn’t it be slightly better to bring marginal down and capital a tad up to be fair?Also, doesn’t this ignore loophole issues?
I think the most important thing for entrepreneurs is to understand and, if appropriate, take the 83b election and excercise their options when the price is cheap. Otherwise it will be expensive and therefore risky to buy and hold to have the 1 year minimum for capital gains treatment.
In addition to the tax advantages that you mentioned capital gains income also results in a form of forced savings. If the money is tied up long-er term it won’t be reduced by the “latte factor” (I’m not a fan of that guy just a way to make a point here) or spent by someone’s spouse “see we can afford that trip this year”.You most likely won’t fritter away money you don’t have in the bank or liquid (assuming you aren’t going to borrow against the asset value etc.)It also actually works out better sometimes if you end up going through divorce as well in some ways.
most people far more than what the tax rate says for income or cap gains. poor ass fools pay more due to monetary inflation that sends cost of living and cost of financial goods up. everybody pays a sales tax, gasoline tax, property tax, higher costs that end up in the final price due to costs incurred with regulatory compliance, etc. when the system is cleared and we can start anew, people will not believe how efficient things are actually meant to be. the era of poverty is coming to an end and a new world order is set to begin.
oh yeah, i also encourage many people, particularly americans, to setup offshore corporations. i’m in the process of doing this. capital goes where it is treated well, which is another way of saying capital will increasingly be leaving the united states.
I’d only add that not all income from non-capital games is the same. I got into books because of the ability to make passive income. While it may be treated the same from a tax perspective, it’s a bit easier than “active” income and doesn’t suffer from the same scaling problem.
Totally agree with your conclusion. In the meantime, we need to set the rates and have them lock in place without the threats of changing on a whim. Then you can look at the next 3 years with a little more confidence rather than worrying about another crazy change.This applies to more than Ordinary vs. CG, moving over to all the other stuff involving investment in future tech.
I recently became a co-founder in a start-up. Long story short it’s an 18month old company that’s profitable and myself and my partners are taking the existing working model and are going to scale it across the US. We did a stock purchase agreement and acquired the assets of the old company and placed them under the NEWCO that is a Delaware C Corp. We set it up this way with the intent of taking outside capital from friends and family at a higher valuation. We did not authorize any preferred shares to date.We have 70mil-authorized shares of common stock and have issued 30mil to the three founders at .001 – me being one of them. 10mil shares were issued to one founder for selling the assets of the old company to NEWCO. The other 20mil were issued to me and the other partner for “services rendered”. We did not fill out an 83B Election and have not purchased the shares at .001. Are we in a position to be looking at getting taxed as ordinary income? The NEWCO is only 2 months old so can I go and buy my shares at .001 (before we take in outside capital) so when we have a liquidity event in the future (most likely a year later) we get taxed on long term capital gains not ordinary income?Thanks!
I understand the principle but can it possibly be right that hedge fund managers pay tax at a lower rate than their secretaries?
Many people (and I believe Fred is one of them – judging by earlier posts) seem to hold the following views about entrepreneurship:a) it’s not about the money. If you are doing it only for the $$$ you are in the wrong business. You should do it because you have a burning need, an uncontrollable passion to pursue your dream because when the going gets tough (as it will) only such passion will sustain you. (I should say that I agree with this)b) the state should give entrepreneurs who get capital gains a significant tax break on those gains because by providing such an incentive they increase the likelihood that people will take the risk of such entrepreneurial activity and thereby allocate capital more efficiently to the benefit of us all.I hope it is blindingly obvious that these two positions (often held simultaneously) are in contradiction.(This is very similar to arguments against taxes increasing state income tax because if they do the rich will vote with their feet and leave the state to states with lower such taxes. (the jury has come back on this one, if anyone is interested the evidence is overwhelming that they do not))Perhaps some argument could be made for hedge fund managers paying less tax than their secretaries if there was convincing evidence that such wealth generation trickled down to the benefit of that secretary, but there is no such evidence – in fact rather the opposite. The evidence of the distribution of the tax burden since the second world war is extremely clear – there has been a remorseless shift of the burden from the wealthy onto the middle class who are being eviscerated.I say all this not because I am some anti-capitalist crypto commie – I founded a successful company, exited well and pay plenty of tax. I also recognize that the government does indeed waste huge sums of money. But at the end of the day IMHO opinions on public finances & tax strategy should not be determined primarily from one’s own selfish financial interest. Roads have to be built, police and health paid for – directly or indirectly – and someone has to pay for it. You either have a system that embodies a modicum of fairness or you jettison that notion, legislate in line with whoever has the most lobbying dollars and devil take the hindmost. That road will doubtless further enrich the rich and inspire the wannabes but it is a sure road to a banana republic society.
Interestingly, the US is actually viewed as a high-taxed country when it comes to gains from innovation. While the US ordinary income tax rate continues to climb over the years and with deficit concerns looming, this trend would not appear to reverse in the near term. As for capital gains, many other countries have far greater tax policy incentives to build companies, particularly start-ups. Using Canada as an example, capital gains rates are 1/2 of the ordinary income rates and for private companies, generally speaking, the first $750,000 of the gain is completely tax free! With all the innovation going on in the US and the unique entrepreneurial spirit, can you imagine what this could do to really drive company building in the US.
I found that a quantity of the most valuable things I learned in business school were not the finance issues, but the people leadership & management principles. I want to see you share a quantity of those areas along with your readers.Auto Auction
This is in reference to the exchange earlier in the thread, but if you haven’t already, take a look at this graph: http://www.businessinsider….From the late 30s to the early 60s the top marginal rate was 80%+ and the only other time it has dipped below 65% was in the run up to the Great Depression so calling our current top marginal rate oppressive is ridiculous.What we really need is an overhaul of the tax code. Those at the very top often pay lower effective tax rates than middle class individuals, which is absurd. As is the fact that companies like GE and Exxon pay no income taxes at all.The government should treat companies and individuals differently based on their means. Startups should be lightly regulated and lightly taxed but by the time a company gets to the size of GE they should get no government assistance at all, just a big and completely unavoidable tax bill.
I dunno, Fred. I think one of the problems with favoring capital gains vs income tax is that capital gains are more likely to be made passively. This creates a troublesome favoritism towards scaling revenue that already scales readily.
Fred,A little more complex than you make it out to be. I think we are missing the fact that companies do get taxed too (unless its not making any profits – but its value is going up significantly). Most companies make profits and pay their taxes (at higher than cap gains).
Hi Fred. You forgot to mention the hiatus (jobs / reinvestment bill) that was signed by Obama exempting capital gains for any qualified investment in a private company for 2010 and it was extended through 2011. These are for investments held 5 years or longer.
Fred, this was a great post and I felt a bit bad (not sure why) because I didn’t have much time the first half of last week to reply to anything major – and this topic deserves some thoughtful response. You had a load of great feedback from your community already but I still wanted to contribute. Brad Feld posted an interesting blog entry today (5/9/11) and some of what I would have said in reply to your post I have posted on Brad’s site if you are interested.http://www.feld.com/wp/arch…You can also find a copy of my reply to Brad’s entry on my blog.
Do you think it would benefit the country to differentiate capital gains that create jobs versus capital gains that do not create jobs? Specifically, a construction company buying in a new crane from Caterpillar creates jobs in the USA. Buying stock in a DOW 500 company does nothing to create jobs. I think capital gains from financial instruments should be taxed as regular income. Even those who own IRA’s take the gains when their income is at tax rates probably lower than the capital gains tax. Do you agree with this analysis? It would do a lot to reduce the federal deficit and might put Warren Buffet in a higher tax bracket than his secretary.
i’m in favor of less complexity in the tax code not morei like a simple flat tax with no deductions and no taxes for those under acertain income level