Entrepreneurs as tax dodgers

It’s a little early for April Fools, and perhaps it is just my long exposure to entrepreneurs, but there is actually an argument circulating which labels entrepreneurs as tax cheats.  This is because entrepreneurs, when (and if) they realize gains on their equity, pay capital gains tax rates on the stock appreciation, instead of the higher rates used for ordinary income. These entrepreneurs, the theory goes, are shifting their pay from higher-tax-rate salaries to lower-tax-rate capital gains, cheating the IRS out of their due.

Now there are some considerable parallels to the carried interest debate (where fund principals pay lower tax rates than their assistants) but in this case I think intention is everything. Investment partnerships pursue a portfolio approach, limiting their risk (that is, risk above the often substantial management fees).  Entrepreneurs have all their eggs in a single basket, and particularly in the initial stages of any company, forgo market salaries out of necessity, not choice. And to attract capital most entrepreneurs need to display “aligned interests” with investors – salary below market and a substantial equity stake.  It’s not a tax dodge; it would be a significant professional disadvantage for an entrepreneur to take a market salary.

However the corollary of this criticism posits an intriguing idea.  Imagine, for a moment, that one could get an equivalent tax write-off on the difference between a entrepreneur’s salary and their market value.  The incentive for executives who lost their jobs to try starting their own business for a year or two (or at least the time it would take to find a new corporate suite) would be considerable.  And it would be blatantly and unethically manipulated, which, of course, is the opposite of what is happening when entrepreneurs take smaller salaries and large equity stakes.