Taxation Of Carried Interest

The issue of how to tax carried interest, the profit sharing interests that VCs, Private Equity firms, and Hedge Funds receive as compensation for generating returns to their investors, is in the news again.

This time it is not a debate at the Federal level, but at the state level. There are carried interest taxation bills under discussion in California, Illinois, Maryland, New Jersey, New York,Rhode Island, and possibly other states that I am not aware of.

My view on this issue is simple and I’ve stated here publicly and regulary since mid 2007.

If you are being paid a fee for managing other people’s money and have no capital at risk on the carried interest, I don’t understand how it can be considered a capital gain.

It may be good economic policy to incentivize people to manage other people’s money and maybe there should be some tax break for doing so. That is a different conversation in my view. Though I don’t buy that one either.

But capital gains tax rates should only be available to those who put their own capital at risk. Many VCs do that in their funds. The partners at USV make up a sizeable portion of our funds. We should and do get capital gains treatment on those investments.

But we also get capital gains treatment on the carried interest and I’ve never understood why. I think it’s wrong.

Finally, because I’ve written these thoughts here before, I know that some will say “well then you should be sticking to your principles and paying ordinary income rates on all of that carry you have received over the years.”

I don’t think that is right either. If the government sets the rules, and everybody else is playing by them, I don’t think it makes sense to play by different rules. I do think it makes sense to explain why you think the rules are wrong. Which is what I am doing here.


Comments (Archived):

  1. jason wright

    rhetorically, i wonder what the counter argument to your POV is, and who is pushing it to become legislation?

    1. Tom Hughes

      The counter-arguments, as I understand them, are two. (1) is that private-investment managers (VC, private equity, hedge funds) are ultimately paid out of capital gains and that the fees they receive along the way are more about smoothing irregular cash flows; in the end, they’re evaluated on, and paid from the proceeds of, asset sales. Argument (2), which Fred alluded to a bit, is that these firms — VC most of all — support innovation and risk taking.I happen to agree with Fred that the favorable tax treatment should extend only to capital directly at risk, but the counter-arguments do have some merit. There’s a tendency (followed by Trump during his campaign and then reversed in office) to talk about this as some kind of fat-cat favor. I don’t think that’s fair.

      1. Pointsandfigures

        the management fee is taxed at whatever rate it hits inside the tax code, we are only talking about the gains from investment. By the way, under the uniform small business act, the first $10MM of gains are tax free.

      2. Mike Marcantonio

        Carried Interest is capital at risk. It’s a key element of the economic contract between LP and GP. If the GP did not receive Carried Interest as part of the arrangement then they would most certainly charge a higher annual management fee to manage their investors money. By structuring the arrangement with part of the compensation in the form of Carry they are taking the risk that those “fees” (carry) materialize into something over the next 10 years. Alternatively the GP could just charge a higher annual MGMT fee and pay the higher ordinary income tax rate in echange for not taking the risk associated with carried interest.

        1. Tom Hughes

          Fred’s original post distinguished between GPs investing alongside LPs — clearly that is capital at risk — and GPs acting in their role as managers. In that second role, the position of a GP is akin to the role of a manager in a conventional stockholder-owned company, who gets a salary and, if they do well at that job, a bonus in the form of equity. The former is treated as current income, the latter is taxed as capital gain on sale. I’m not sure I see the risk accruing to the GP in that second role: they know they will get paid along the way. If they were subject to clawback if the fund didn’t return more than its original investment, then it would truly be risky. In effect the fees would be borrowing against future gains; but that doesn’t happen that I’ve heard of.

  2. A

    Say I’m a VC… What stops me from borrowing 20% of the cost of the investment from my LPs, at a zero interest rate, with no recourse, and get the same outcome (20% of the profits), as capital gains?

    1. andyswan


      1. Michael B. Aronson

        if this ever changes at the Federal level, there will be a lot of creative (re)structuring of the economics of GP LP relationship. Although I think this may happen anyway with tokens, blockchains, crowd sourcing, pass through entity taxation, non deductibility of investment fees et al

    2. PhilipSugar

      You can’t loan money at a zero percent interest rate without a tax consequence.

      1. A

        Make it 6% and that effectively becomes the return hurdle? Easy to structure.

        1. PhilipSugar

          It would be harder to justify and it would essentially half the carry.Here is the issue: When you are managing others money you are much more loose with the terms than the people who’s money you manage. Also since you manage money, you make a lot of money, and therefore it doesn’t really bother you as much.You see this in the U.S. on the pay of CEO’s (and VC’s) for instance.Now the question is if that money was returned to the actual people would they spend it and help the economy (yes). But you also need people that invest money in order to serve those that spend the money (with big capital)

      2. JLM

        .You must “impute” an interest rate.JLMwww.themusingsofthebigredca…

        1. A

          How do you impute that rate?

          1. JLM

            .IRS tells you the imputed interest rate.JLMwww.themusingsofthebigredca…

  3. andyswan

    Capital is bettter utilized by you than by the government. Keep what you can.Side note: The rest of the country is more than happy to accept NY and Cali’s taxfugees…just leave the policies there!

  4. Eric Friedman

    This is a great debate – it is too bad the old comments sections and discussions seem to be missing (hidden?) because they are now closed. I remember wading through them in 2007 and wanted to jump back in but they don’t seem to be there.

    1. fredwilson

      i can probably get them back. i just need to mess with URL structure. i wish i had more time to fix stuff that’s broken at AVC

      1. jason wright

        not enough hours in the day for that wish.

      2. JasonBoisture

        Fred, perhaps there’s a reason you haven’t had someone help you this with already, but as regular reader, occasional commenter and WordPress developer for the past 10 years, if there’s anything I can do, please reach out: jason [(-a@t-)]

  5. PhilipSugar

    Could not agree more with this post. Every bit. All of these loop holes cause so many issues.

    1. JLM

      .What you are calling “loop holes” are, in fact, well founded partnership taxation policies which have been settled laws for decades.If you and I were partners in a paint company, we would be taxed like a partnership receiving annual K-1s allocating our share of the annual profits. This would be taxed like ordinary income because it is.If our partnership made a capital investment (for simplicity, let’s assume we borrowed all of the money), and we hit a good lick, we would receive our annual K-1 with our share of the capital gain. This would be taxed like capital gain because it is.This is just simple partnership tax accounting, nothing more.JLMwww.themusingsofthebigredca…

      1. PhilipSugar

        Here is my thing, you could really simplify things if you said, you get to deduct expenses paid for items or people in the U.S. not for the rest, deduct dividends but tax to those who receive, just set a low corporate tax rate, fixed personal tax rate, no capital gains, and a earned income tax credit, i.e. you have to be employed to be on the dole, then I am good.

        1. JLM

          .I was talking about a single “loophole” not the entire IRC. If one really wanted to reform taxes in a meaningful way, it would start with restricting the size and growth of government.Since taking office, Pres Trump has reduced the Federal payroll by 24,000 jobs. That is huge. At the same time in the Obama admin, he’d grown it by more than 100,000.We need to get serious about the size of our deficits, our national debt, and our government.The solution is always more tax revenue. More taxes. More spending. It is spending which is driving everything.The Dems are, literally, running on a promise to roll back the Trump tax cuts and to raise taxes.JLMwww.themusingsofthebigredca…

          1. LE

            has reduced the Federal payroll by 24,000 jobsWhat is the correct amount of federal employment though? Better to have people earning money doing something than out of a job and/or collecting some kind of government benefit or not able to pay bills.An example that I have used is the (assumed to be and potentially corrupt) PANYNJ (Port Authority). Plenty of people living off of tolls to get in and out of NYC (and other revenue sources). The question is if that money was not paid in tolls and those ‘lard’ did not have jobs what would they be doing? Who would pay the taxes on the property in Staten Island and buy the pizza’s at the local pizza shop?Ditto for many overpaid and restrictive union jobs. Detroit metro was doing ok prior to those jobs going out the window with imported autos and competition. This is not an argument for why inefficiency is good. Just acknowledging that there is an upside that needs to be factored in.

          2. PhilipSugar

            Make them find jobs somewhere else.

          3. JLM

            .State governments increase size with population unless, like Texas, they have efficiencies. Most of the losses at the Federal level are related to programs which are being – hopefully – eliminated.JLMwww.themusingsofthebigredca…

          4. PhilipSugar

            Could not agree more about the size of the government. Technology has reduced the number of administrators everywhere but the government. The number of government employees should be getting decimated right now.Let me tell a quick story (I always do). I am at the feed store yesterday. I tell the owner, I wish you would repackage the bags of a certain fertilizer because I only need half and I don’t want to store. I’d pay a 20% premium no problem.He goes into a rant. The government ag guy comes in. I did that and he said he would close me down that day. He comes in and knocks stuff off of my shelves and says: “not marked” correctly. He punches holes in bags to check samples and I say how do I sell that now?? He says I’ll shut you down. I have to get a “license” to sell my organic tea, now everybody else can.Literal quote: “I want to punch him his f’ing suck hole he better pray anarchy never comes because I looked up where he lives and I will be there with more than fists or sticks”

          5. LE

            Literal quote: “I want to punch him his f’ing suck hole he better pray anarchy never comes because I looked up where he lives and I will be there with more than fists or sticks”Sounds like an immense amount of frustration for sure. I can actually empathize with that. But taking the other side maybe he shouldn’t be considering violence (even hypothetically) and instead use brains and creativity to get a better situation. Would you make an investment in that feed store owner? I wouldn’t not a chance. If you were a legislature would you listen to him?We both have discussed how we have different ways of getting to the same place with people (your example of how you deal with cops). I consider it a game to get one over by using my head on the opponent. But the fact is we give it thought and strategy and don’t just result to the obvious impulsive reaction to a problem. Brute force and/or emotion.What would you tell your kids? I would tell mine that the ‘owner’ is wrong in his approach to this type of adversity. Wouldn’t you?

          6. PhilipSugar

            He has immense knowledge. Remember what I look like when I come in. He convinced me not to buy some grub killer because if I hadn’t put it on my yard now it wouldn’t matter until September. I buy literally tons, literally tons of stuff from him. He does an amazing business.I would because I would put a different face on it, and I have government connections he does not. I would call the Governor and have that guys boss dressed down. It should not be like that.Now it does bother him that people ask him questions and then go price shop at Home Depot across the parking lot. Email me I will give you his website.

          7. LE

            Now it does bother him that people ask him questions and then go price shop at Home Depot across the parking lot.Oh yeah people do that and it has gotten even worse because of multiple factors:a) Younger people entitlementb) Lack of empathy for the business owner.c) Lack of understanding of how business works.d) “It’s all about me”e) Big box ‘bend over and grease up’.f) Starbucks ‘sure use our bathrooms no problem’You’d be surprised at the number of times that we get calls asking for instructions for ‘how to switch to a different XYZ’. It’s like people are brain dead. The idea that you ask the firm you are leaving for instructions on how to switch to a competitor defies logic at all levels. What are you fucking 10 years old?Back when I started in business nobody would do this. It would be literally in the middle of the night with no advanced warning at all.When I was 10 years old I picked up pictures at the fotomat kiosk. I then went into the camera store and asked the clerk why the pictures came out bad. He said he wouldn’t tell me that “I had bought them from fotomat”. Later I complained to the owner. He of course backed up the employee and got even madder at me!. But I was 10 years old (or whatever age who knows). I remember at that time thinking ‘wow I am stupid for thinking they should help me’. People don’t feel stupid for what they do anymore they think it’s the other guy who needs to make a change.

          8. Adam Sher

            People get very upset when you try to hold them accountable for the job you paid them to do. Eyeglass store owners (in Philly) are particularly egregious offenders.

          9. Adam Sher

            It is easier to intuit the importance of the service aspect of a business, and who should be responsible for satisfactory delivery, when you are, or have been, a business owner. Until you’ve walked a mile in the owner’s shoes, you may assume every business in the business of x is responsible for your satisfaction from purchase y.

          10. PhilipSugar

            We agree 100%. I can’t think of having the audacity of asking somebody whom I bought from their competitor who has no clue but sells on price for advice.I have gotten this, somebody calls up and asks for advice but is not a customer. Ok, how are you going to commit to become a customer? Oh, you aren’t. No help.

          11. nybble41

            “When I was 10 years old I picked up pictures at the fotomat kiosk. I then went into the camera store and asked the clerk why the pictures came out bad. He said he wouldn’t tell me that ‘I had bought them from fotomat’.”That certainly doesn’t sound like very good business practice. The camera store missed a perfect opportunity to explain exactly how their photo developing service is superior to the fotomat! Besides, their approach has a good chance of alienating potential future buyers of cameras and related accessories, even if they do continue to develop the photos somewhere else. Or worse, discouraging interested individuals from taking up photography altogether.

    2. LE

      All of these loop holes cause so many issues.As a pejorative things are called ‘loop holes’. But the fact is many tax benefits are in order to create behavior that is advantageous in some way. You create a tax incentive and towards another goal.

      1. PhilipSugar

        You had a printing company. Lets say RR Donneley came in and NJ said….we love you, great to relocate from Lancaster, not only no taxes for you, we give you millions to build your plant next to your plant.How do you feel?

        1. LE

          That is probably not a good example actually (not that I don’t get your point). RR Donneley building a plant would have been great for me. [1] Xerox (Repro Centers HUGE) was doing the exact same thing as we were. I got them as a client for overflow work. When I had ZERO employees I beat them for a local hospital system contract $250k in early 80’s dollars. Me and my down vest (nobody dressed like that back then when selling to a business but I did) vs. their suits. Ditto for the established operation up the street. Laughed at first then sent me business.Now to the point you are actually making and question you are asking. Would I feel good about something ‘like that’? Of course not. But I am in business and that is why I work so hard. Because you never know what is coming around the corner there are no guarantees. I understand that is the case. I can and do have to accept that risk. I like the fact that my balls are not in a vice like a corporate employee is.I was at a wedding and a top attorney for Comcast (who lives in our neighborhood; and it’s not a fancy place btw) was at the table. I spoke to him once before at another affair. And this affair I didn’t even talk to him. Why? Because I already knew that since he worked for Comcast and was an attorney I would never get him to say anything that would be of interest to me other than things he felt he could say. His balls were in a vice. He has to watch everything he says and does. I love the fact that I don’t have to do that. That is the tradeoff and the upside to me. Note he would be boring as opposed to the feed store owner who is interesting (and that is what I like either I learn something or I am entertained).[1] If you are small that is the type of thing that can and does happen. Plus it brings more economic activity to the area.

          1. PhilipSugar

            We agree completely. Even saying “your balls are in a vice” gets you in trouble with the PC police. Notice how Duluth Trading has made a business by not being PC. Their tag line on why to buy their underwear? They show a guy with your description. Their tag line to buy pants which they call “ballroom pants”: “get a pair” in a way we know what that means. They have an ad for long t-shirts that cover up your “plumbers butt”Now there are people that get so offended at this. But their reaction has caused a backlash. They are a huge growing retail chain in this tough market. Duluth Trading came out with a women’s line because so many women (like my wife) loved their commercials and came into their store to try and buy stuff even though it wasn’t sized right for them.Cabella’s was the same.Look if you say women are not in anyway equal to men in ability, I will block you (and I have done to someone on this board)But that does not mean we have to be totally PC.

          2. sigmaalgebra

            Look if you say women are not in anyway equal to men in ability, I will block you (and I have done to someone on this board) Yes, with PC and some related recent twisted out of shape culture, there are some kindergarten teachers all confused and that leave some of the male students confused.But when the boys grow and meet girls in grade school, they learn more.For normal boys, by the time they shave, they start to understand women!For the boys who had bad kindergarten experiences and are still confused, by the time they shave they will likely understand.Or in the words of E. Fromm in The Art of Loving, Men and women deserve equal respect as persons but are not the same. Yup, until a boy starts to shave, he might get confused on this point!There are a lot of badly confused people out there, including some who might have been shaving for a long time.One expert on women once stated:Of COURSE, women are MUCH more emotional than men. Of course, we’re talking about generalities, distributions, and averages; individual cases are free to be nearly anything. In a lot of ways, men and women are not at all equal:E.g., women are MUCH better with people, e.g., have much better social understanding, insight, and skills, are much better at perceiving what others are thinking and responding effectively.The US military has discovered that on really long, stressful athletic events, lasting days, women have more endurance than men.Women have better verbal skills and do significantly better on the Verbal SAT tests.My experience is that women are significantly better at going without sleep than men.Girls have better manual dexterity than men, better rote memories, better color sense, etc.Women are more anxious than men, e.g., even across cultures, are four times more likely to suffer from severe anxiety disease — David V. Sheehan, M.D., The Anxiety Disease. Boys do better on the Math SAT tests and have better 3D spacial relations than girls.And there are other differences!But, again, most boys learn these lessons by the time they shave! Right, a few misled, slow learning “losers” don’t.

  6. Pointsandfigures

    I disagree. Why? Because of risk/reward. Because society benefits by having investors invest in innovation.In commodities, it’s a blended rate. 60% at the top rate, 40% at long term capital gains which works out to 20 some percent. It recognizes the risk transfer function being done in the market. Treasury Note spreads would be much wider and it would be more expensive for the government to auction off debt if that tax rate didn’t exist.I do agree that a VC should have money in their own fund.

  7. Michael B. Aronson

    On the other hand ,us VCs pay taxes (yes at capital gains rate) on profits we don’t even receive as portfolio companies are sold at a gain but before the carry kicks in on a cash basis (under waterfall investors get their contributed capital plus pfd returns before a nickel goes to the GP). I know this is a big issue for more junior GPs. I agree conceptually that there is little reason for carry to be at CG rates especially for PE firms

  8. Mark Cancellieri

    “If you are being paid a fee for managing other people’s money and have no capital at risk on the carried interest, I don’t understand how it can be considered a capital gain.”I agree wholeheartedly. You are basically providing a service, and your clients transfer assets to you in exchange for that service. In most businesses, a client would pay you in cash for your services, but in this case it is an interest in the portfolio assets. No matter the form of payment, it should be ordinary income if we care about being logically consistent (not that politicians care much about being logically consistent).I also believe that you shouldn’t pay more tax than the law allows, even if you disagree with the law.”Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”- Judge Learned Hand, Helvering v. Gregory

  9. JLM

    .This is actually pretty simple tax theory and policy. I dealt with it for decades as a real estate developer and re-developer of high rise office buildings. It is all about risk.The trail begins when you select the legal entity under which you are going to operate. You can – theoretically – be a sole proprietor, a partnership, or a corporation. You could also – theoretically – be a trust. Most VCs and real estate developers of size will elect to be partnerships.This deliberative election of taxable entity is what sets your method of taxation, nothing else.Most VC funds are structured as limited partnerships. This results in the designation of a general partner and limited partner(s).The general partner, subject to the partnership agreement document, is solely responsible for managing the partnership’s business affairs. There may be a number of guard rails in the partnership agreement, but the GP is the manager of the enterprise – the “active” partner.Certain entities — pension funds, endowments — have to be limited partners as they cannot be involved in active management of business affairs by charter and want to avoid something called UBIT (unrelated business income tax). UBIT makes their tax exempt status meaningless and opens them to risks of all kinds.As passive investors/partners, they write checks and receive checks, but they cannot participate in the management of the enterprise.In return for being a limited partner, such entities are shielded from any and all risks of loss beyond their original investment and any untoward acts of the enterprise. Their limited partner status shields them from all other liabilities.OTOH, the general partner is liable for all of the bad things that can happen to any business enterprise. In the event of individuals owning that general partnership entity (meaning USV and, ultimately Freddie) a plaintiff or claimant can try to “pierce the veil” of the enterprise and go after the personal wealth of the individual.This piercing approach is even used when the participants are corporations, but it totally unremarkable when you are dealing with partnerships.This risk is the investment of the general partner when they do not invest actual capital. They are undertaking all the contingent risk of the enterprise.The fact that the general partner doesn’t invest any actual money is simply a tax matter associated with establishing “tax basis” for the purpose of calculating gain – which in virtually every instance would be long term capital gain.The general partner invests talent, time, and risk.The limited partner invests cash.The general partner has no tax basis in his investment.The limited partner has a positive tax basis in his investment. [Note: most LPs are tax exempt entities, so the entire discussion of their taxes is moot.]The rest of it is just accounting. Simple partnership accounting. Nothing more.To flesh it out just a bit more.1. GPs receive an annual management fee which is taxed as ordinary income. You can argue this keeps the lights on at the management shop.2. GPs receive a “carried interest” in return for their investment of time, talent, and risk.3. GPs may also benefit from what is called the Qualified Small Business Stock provision of the Protecting Americans from Tax Hikes of 2015 which essentially makes the first $10MM of taxable gain exempt from taxes.If you have been in business for more than two weeks, you have been sued a few times. You have likely been sued in your personal status even though you had nothing to do with the complaint in a personal capacity. It happens. Plaintiffs love to screw with the guys who run things even when the guys who run things have something called “prudent man” protection.As to the states who are dealing with this now – they are greedy bastards by invoking a state or city tax in the beginning of things.Move to Texas or Florida where there is no personal income tax and the problem disappears.Partnerships are taxed differently from corporations because of the risk exposure.JLMwww.themusingsofthebigredca…

    1. LE

      Not my area of expertise but I will note that I think that this statement you made (which makes an excellent point in support of the topic being discussed)::OTOH, the general partner is liable for all of the bad things that can happen to any business enterprise. In the event of individuals owning that general partnership entity (meaning USV and, ultimately Freddie) a plaintiff or claimant can try to “pierce the veil” of the enterprise and go after the personal wealth of the individual….is lessened in impact by this statement:If you have been in business for more than two weeks, you have been sued a few times. You have likely been sued in your personal status even though you had nothing to do with the complaint in a personal capacity. It happens. Plaintiffs love to screw with the guys who run things even when the guys who run things have something called “prudent man” protection.Not everybody is ‘the big guy in the bar’. Might surprise you that there are plenty of small guys who have never been challenged in a bar because a) They are small and don’t appear to present a challenge and b) They are good at dodging and avoiding in their actions potential conflicts.

      1. JLM

        .I would note that the VC business is fraught with failure. Failures spawn controversy and controversy spawns legal action.Big time real estate is similar in that when the tree huggers lose at the City Council and Planning Commission, they sue you. Because suing you can delay your project.JLMwww.themusingsofthebigredca…

        1. Adam Sher

          My father in law wanted to redevelop his beach house in South Jersey, which only benefited everyone on the block. Unfortunately, a single dissenter from the block would, and did, hold up the township’s approval indefinitely. The dissenter would not be reasoned with. My FIL waited until the dissent passed (not an intentional strategy), and then proceeded. Waiting for that on a commercial project may mean the window of opportunity passes.

          1. jason wright

            you mean waiting for the dissenter to die?

          2. Adam Sher

            That’s what happened in this case. Not a great strategy in general.

          3. jason wright

            passive, or criminal 😉

          4. Adam Sher

            Maybe a criminal use of passive voice.

          5. LE

            Interesting have you ever read the story about Vera Coking?…Curious is your FIL’s last name begins with the letter “Y” and/or the town begins with “M”?

          6. LE

            I am working on a deal to buy something from a woman who is located in Japan. She doesn’t want to sell (at any price) not to get a high price (which is ordinary and typical) but because she doesn’t want to ‘disturb the dead’. It, from what I have been told by experts (including the head of a University language department), is a Japanese thing.Anyway given the right amount of money the deal could be done I feel. You just find something else that could guilt the person into agreeing. In the case of the Japanese woman (who apparently either doesn’t want money or feels dirty), well, we could make a large donation to a hospital or toward a cure for what her son died of. My point is when money doesn’t do the trick you at least attempt to manipulate in some other way.Also it is definitely not unusual that someone wouldn’t want to relocate because it’s their personal aggravation. For example I wouldn’t sell my office for even twice what I paid for it. I don’t want the aggravation of having to move. Now if someone said they would give me 2x plus take care of all the aggravation then I might consider. Not definitely but that is my objection. Not saying Reidy’s is the same. Point is like with anything in sales you try to find the root cause. Noting that my office is not in a rising RE market btw. Not sure it’s worth what I paid even.Once I had a guy that didn’t want to sell and he said he couldn’t sell for legal reasons. I figured out he was getting divorced and didn’t want to share money with his wife. Told him we would hold out until that happened. Plan B? I simply go to the wife directly and do the deal that way. Problem solved. Luckily didn’t have to do that.

          7. Adam Sher

            I hadn’t read that story. Thanks for the link. Yes, those letters correspond to my FIL and town.

          8. J3

            One of the Herbie the Love Bug movies used that as a plot–giant office building that needs one small lot for completion. Who knew it was based on a true story?

    2. Adam Sher

      In other companies where you invest time, talent, and risk (i.e. services for equity), you receive equity that is taxed at your income tax rate. You gains on that equity are then taxed at capital gains.The management fees at funds above $300M in equity under management fund a lot more than the lights and the analysts. Diligent GPs are insulated from the financial consequences of GP risk either via insurance and/or the way in which they enter the partnership.I’ll bet you a drink that other than maybe your first couple of real estate deals, your were not financially exposed even though you were the GP.

      1. JLM

        .A nice mojito would be fair play, thank you. On second thought, how about a pitcher of mojitos?As a GP in the RE business, you are personally liable even for a non-recourse loan if there is any whiff of inadvertent misrepresentation, impropriety or fraud. This can be as simple as having an error in the affidavit submitted to obtain the zoning, subdivision, utilities, or the building permit.During construction, a GP takes personal liability for any construction failure. You are right it can be insured against with a performance bond, but insurance costs money and it is virtually impossible to insure away the first tranche of liability.Insurance programs usually start with some lower amount of self-funded deductible, followed by a million dollar policy, and a ten million dollar umbrella and a $50-200MM excess liability umbrella.Property insurance is insane though it is often structured the same way.Small – $1MM – self-insurance, primary insurance, umbrella, excess umbrella. People focus on the cost, which is not inconsequential, but it is really the coverage which is important.I had thousands of non-smoking apartments in Austin, Dallas, Houston, San Antonio and had a tenant come home inebriated, smoke a cigarette, and burn down 16 units. He was killed.It turned out fine because we could prove we’d had the smoke detector batteries changed the exact day of the fire and we had perfect records, but it could have gone very bad for us.I am not aware of any way in which one can “enter” a partnership which limits GP liability. You can use a corporate general partner, but that attracts more trouble than it is worth because if it is “pierced” they can go after the shareholders individually. It is infinitely better to try to limit the liability with a legally compartmentalized bankruptcy defense.There is also the issue of “active” v “passive” which clouds the issue. You cannot deduct the interest and depreciation costs if you are not an active partner. They are golden.Make sure to use fresh mint. Bruise it.JLMwww.themusingsofthebigredca…

        1. Adam Sher

          A GP can be judgement proof. That may not stop someone from bringing a claim, particularly if you breach a bad boy provisions, but you won’t have much money at risk.

          1. JLM

            .Nobody is “judgement proof” as long as they have earning power. This is a myth.If someone obtains a judgement against you, they have the ability to attach your future earnings unless you are willing to file for personal bankruptcy which kills your long term business prospects unless you are investing solely funds you unilaterally control.JLMwww.themusingsofthebigredca…

    3. JamesHRH

      Great review, as always.Isn’t the simpler answer that the VCs are being paid with a share of the gains on the invested capital?The partners are not paying them separate via funds……the carried interest is actually the proceeds of the LPs capital being invested, realizing gains, but then being shared with the GP……so its capital gains sharing and s/b taxed as a capital gain?

      1. JLM

        .Literally, a partnership files a tax return for the partnership which allocates – via K1s – the results of the partnership to the partners.The character of the gain (or loss) is dictated by the IRC as it pertains to gains and losses at the partnership level.The partnership simply allocates the results – as you note.Post allocation, the recipient simply folds that information into their own personal tax status.This is all a bunch of liberal virtue signalling.JLMwww.themusingsofthebigredca…

        1. JamesHRH


          1. JLM

            .Internal Revenue Code – the Tax Code.JLMwww.themusingsofthebigredca…

  10. jason wright

    the plutocracy would be on borrowed time without taxation.

  11. Scott Gutterman

    Fred, the construct of carried interest makes sense from a tax perspective. If you and I invest $100 and we turn it into $200 over more than one year, we agreee there are $100 of profit. The government is entitled to the capital gain rate * $100. How you and I decide to divide the profits shouldn’t really affect how either one of us get taxed.Why should GPs covert capital gains from the above example into ordinary income. The perception is that all GPs are rich and make a lot of money so let’s tax them at higher rates.You are paying ordinary tax rates on management fees for your services, however how the profits get divided should be of no concern to the government and it’s not in the way that carry currently works.

    1. Tom

      Total agree: “The government is entitled to the capital gain rate * $100. How you and I decide to divide the profits shouldn’t really affect how either one of us get taxed.”Also,if the $100 capital gain is a function of increase profit or profit potential (which usually are), the government is already (also?) entitled to the income tax of those profits or profile potentials as corporate tax, and as personal tax when it is passed on as dividend to the individual. (other countries recognized it as a double-taxation and have rules to reduce the tax-paid on dividends by the estimate amount of income-tax on corp level.)Captial tax, thus, is a third taxes on the same profit or profile potential.

  12. ErikSchwartz

    Yup. I totally agree. I too have never understood this one (other than there is a powerful constituency that wants a tax break).

  13. Mark

    There should simply be no favorable treatment of capital gains.That actually solves all the problem. And as the 1986 tax reform showed, it has no negative impact on investing.

    1. JLM

      .There would be no capital gain income which would reduce the revenue to the Treasury.Business owners would borrow against their holdings – thereby eliminating taxes of any kind whatsoever – and use that tax free cash to support their life style or to make new investments.Capital gains tax treatment motivates owners to sell locked up profits for liquidity.JLMwww.themusingsofthebigredca…

    2. Tom

      if the capital gain is a function of increase profit or profit potential (which usually are), the government is already (also?) entitled to the income tax of those profits or profile potentials as corporate tax, and as personal tax when it is passed on as dividend to the individual. (other countries recognized it as a double-taxation and have rules to reduce the tax-paid on dividends by the estimate amount of income-tax on corp level.)Captial tax, thus, is a third taxes on the same profit or profit potential.There are very strong reasons to tax capital gain less, because it is a third tax on the same profit or profit potential.

  14. Alan Warms

    Fred, to me, carried interest is EXACTLY like ISOs you issue to management. They get ltcg on those.. So should VCs, PEs, who are doing a ton of heavy lifting in partnership with management to do so

    1. Adam Sher

      VCs and PE fund managers are asset managers. They receive wages and deal bonuses for buying and selling assets. Carried interest is just a deal bonus that is called something else, and consequently taxed as something else. I’ve been a fund manager, and it didn’t make sense then to treat my carry as a capital gain. I had no skin in the game. I’m just taking the gain on someone else’s capital.

      1. Alan Warms

        VC and PE are a lot more than asset managers. They roll up their sleeves, work hand-in-hand with executive teams – in PE’s case they actively provide direction and often corp dev leadership. Much much different than asset manager of public securities.

        1. Adam Sher

          I’m only referring to the private market. The VC and PE investors should provide value as members of their portfolio companies’ boards. That is not the same as rolling up their sleeves and working on the company. Maybe it’s just terminology, but I interpret rolling your sleeves up and working hand-in-hand as part of operating a business, which again, investors are not. I’m exclude a minority of funds whose edict is to operate the businesses they invest in.

  15. iggyfanlo

    FredIt’s rare that I see both radical honesty and radical pragmatism. I think your stand that carried interest SHOULD be taxed but if it isn’t you should play by the rules is spot on.Good for you

  16. Richard

    Yes, mark this day down as Fred position being absolutely correct. VCs work on commission, commision are taxable.

  17. L

    I respect your position but I have a different personal take:1) I agree it’s weird that carry is taxed at capital gains rates and not as income.2) I disagree strongly that this should be legislated at the state level. Either carry should be taxed as income across the US, or it shouldn’t. Otherwise someone in Maryland can move 10 miles away to DC and avoid a 19% tax. That’s crazy.3) Not sure about other proposals, but the proposal in California is for an additional 17% flat tax on carry. That’s egregious — especially on top of the highest state tax rate in the country. It’s very possible to actually pay more under the proposed state tax than if the carry income was taxed as regular income in the first place.4) One argument in favor of taxing carry differently is how lumpy it is. You don’t make $250k/year every year; instead, you make $2.5m in year 10. The difference between 10 years of taxes on $250k extra income vs. 1 year of taxes on $2.5m extra income is huge.5) Finally, one side to this question is “what’s right thing to do?” and the other side is “what will the side effect of these laws be?” They might be the the right thing to impose on the federal level, but at the state level I think they will just lead to a lot of investors moving to tax friendly locations, doing more phone/video meetings, and flying into tech hubs once a week. That will increase startup funding in lower tax states, but hurt funding in the tech hubs located in states proposing these tax changes. The power law holds for taxes, too: if VCs move to Nevada and the next Facebook is founded in Nevada, the lost tax revenue will hurt California much more than the carried interest tax revenue will help.

  18. Bob Pavey

    Vinod – you and I agree on most things but I believe you are wrong on this issue. Several points:1) I do agree that there should be no capital gains treatment for carried interest in a gain of 13 months, but that has been corrected in the recent tax bill that redefined long term as over 3 years. 2) Your belief that capital must be at risk to get capital gains treatment would lead to the conclusion that our entrepreneurs should not get capital gains treatment on their stock options. I hope you don’t want to treat all gains on options as ordinary income. Do you???3) Carried interest is just like stock options – it is a method for those who have a capital gain to share that gain with those who worked for years to produce it. You and I no longer need carried interest because we are successful venture capitalists (and now invest our own money) but new people in our business often take a lower salary for the shot at an upside driven by their success. They take a risk just as entrepreneurs and investors do.So Vinod, I encourage you to think of carried interest for us the same as stock options for entrepreneurs – a way to share the gains. Perhaps this will give you a new perspective. Our country depends on the entrepreneurs and venture capitalists who create businesses to keep us competitive in increasingly competitive worldwide markets. This is not the time to remove one of the incentives that has made this work.