The Things They Carried

Amid financial and regulatory oil slicks is an ongoing debate about carried interest, which Warren Buffet once characterized by asking why his receptionist was paying a higher tax rate than he was. She did so because investment funds — including venture capital — make money on “carried interest” (or just “carry”) which is the fund’s share of profits from their investments. Carried interest is currently taxed at the capital gains rate (about 15%) instead of as ordinary income (taxed at a rate roughly twice as high). Back in 2006, this allowed Buffet to pay a tax rate of 17.7% on gains of $46 million, while his receptionist paid 30% of her $60,000 annual salary.

Venture capitalists have taken both sides, with Fred Wilson arguing for changing the tax laws both as basic fairness and sound monetary policy, while Gerry Langeler (of OVP Partners) believes that a change would harm investment and makes an analogy with home ownership. Several academic reports have added to the mix of opinion.

There are many tax loopholes for business startups (including this one), and this debate has ebbed and flowed for months, but last week the US House of Representatives voted to change the tax treatment of carried interest, over time, to a hybrid of 25% capital gains and 75% ordinary income.  The Senate takes up the measure this week, and it seems that the hybrid model is likely to prevail at some level. Oddly, the concern over the economy means legislative fear of further inhibiting growth, so the percentage of carry taxed as ordinary income will likely be less than the proposed 75%.  And amid all the sound and fury, the irony remains that fund managers, who often take as their religion the elimination of government subsidies and the level playing field of market efficiency, will argue that they should continue receiving what policy experts gently describe as income “taxed more lightly than almost all other forms of compensation for similar services*“ and what critics call an, um, federal handout.