Lynne Zagami Riquelme came to Brightleaf from a background at Proskauer Rose and Brown Rudnick. At the former, she participated in spirited debates on the subject of carried interest taxation and its implications for the tech economy. Here’s her well-informed take on this in-the-news issue…
In recent months, a lot of attention has been paid to the question of whether Congress, as part of a larger financial overhaul, will change the taxation of carried-interest income for managers of investment funds that are organized as partnerships. In other words, Congress is poised to change the face of private equity and venture capital as we know it.
We know an overhaul is in the works – House and Senate bills are being debated, Elizabeth Warren is talking tough to NPR and ads for Fox News are asking whether America is broke. We here at Brightleaf don’t presume to know the future (and we can’t seem to find a crystal ball on eBay), but we’re pretty sure we’re in for the biggest set of financial reforms since the 33’ and 34’ Acts were passed.
Further, we bet that whatever reform measure is passed will include an increase in an important tax rate tied to long-term investment. Congress has been trying, with limited success until now, to change the tax treatment of carried-interest income, which is the share of profits that private equity, venture capital and real estate fund managers receive as part of their compensation. The problem, according to Senate Finance Committee Chairman Max Baucus (D., Mont.) and House Ways and Means Committee Chairman Sander Levin (D., Mich.), is that carried-interest is treated as capital gains (and taxed at a rate of 15%), when it should be considered ordinary income (and taxed at rates up to 38.5%). Their argument? That the managers running these funds have been paying capital gains rates on money that should be treated as wages because they earn this money for managing other people’s money (i.e. working). Indeed, many proponents of the change argue investment managers should be thankful the U.S. isn’t proposing a U.K.-style excise tax of 50% on managers’ incomes.
So what’s wrong with that argument? There are two important things to note: 1) fund managers take on a lot of risk when they make investments and 2) lots of people benefit when fund managers take these risks. The first point boils down to this – fund managers don’t make money just by going to work, as the rest of us do. Carried-interest, in the context of private equity and venture capital funds, is earned years after an initial investment is made. Further, as Douglas Lowenstein, president of the Private Equity Council, points out, “earning carried-interest involves taking risks . . . and exposing yourself to the possibility that you’ll have to return your earnings if things don’t work out.” The rest of us simply don’t face consequences like this in our professional lives.
Second, saying that keeping carried-interest rates low provides an unfair advantage to fund managers is remarkably shortsighted. When we begin orienting our tax policy around people, and not activities, we set a dangerous precedent. Do fund managers sometimes make lots of money? Yes. But in the process, they provide essential funding to companies that in turn hire U.S. workers (indeed, emerging companies were the only ones to add jobs in 2009). The Private Equity Council’s report on the proposed rate change states that the hike could prevent between 36,600 and 127,800 jobs from being created through private equity investments. Taxing carried-interest at lower rates encourages capital formation, construction activity, and job creation, all of which are in short supply these days. Can we really afford to discourage those activities at this point in history?
We here at Brightleaf are inclined to say no. In fact, we’ve spent the past few years growing and hiring talented workers thanks to the support of a venture capital firm. While other companies were struggling, we were bringing in additional talent to respond to the demands of a changing legal industry. We were advising law firms and corporate legal departments on ways they can incorporate document automation into their plans for the future. And we will continue to do more of this. Whether other companies will be as fortunate as we have been, we’re not so sure.