How Much Should We Tax Venture Capitalists?

I’ve talked a lot about venture capitalists in this space, and it's no wonder why: They play an incredibly important role in helping entrepreneurs raise money. They take huge risks on nascent ideas in the hopes of transforming them into future-shaping realities (and capturing the returns from doing so). However, with a new tax proposal, the VC industry might be in store for a major shake up.

Many VCs make their money through a structure similar to that of hedge funds—what’s called “two and twenty.” They get a 2 percent management fee and 20 percent of the profit on investments (though the exact percentages vary by VC). This latter portion, sometimes called the "carry," is the subject of the current tax debate.

As it stands, a VC’s carry is taxed as a capital gain. Many, however, think these funds should be taxed as ordinary income, which would shift the tax incurred by the VC from 15 percent to as high as 35 percent. Not surprisingly, there was a heavy lobbying effort against this change (largely from hedge funds and private equity firms, who would also be affected). As it stands, a plan has passed through the House that would tax two-thirds of the carry as regular income (see this New York Times article for more information).

While I expected most VCs to be up in arms about the prospect of losing a substantial chunk of their profits (and trust me, they are), I was surprised to see that Fred Wilson and Chris Dixon—two very respected venture capitalists—were on board with the idea.

Wilson brings up a number of interesting points. In his initial post, he explains that the carry should clearly be charged as ordinary income because it is gained through investing other people’s money. More recently, he’s gone on to contend that because fund managers would be taxed at a lower rate on their own investments, the new law might lead to VCs having more skin in the game, which he feels will drive better performance.

Interestingly, Wilson also makes a bit of a moral argument, stating, “If Congress is successful in taxing carried interest as ordinary income, it will massively increase the amount of taxes I pay. So be it. Someone has to pay the taxes to keep our troops equipped, our borders secured, our schools modernized, and our children healthy. It might as well be me and my wife.”

Dixon echoes this idea with his post on the subject, claiming that it “comes down to basic fairness.” He contends, “A fireman who runs into a burning buildings shouldn’t pay a higher tax rate than a financier sunbathing on a yacht eating $400 crabs.”

Knewton CEO Jose Ferreira takes the other side of the debate, positing, “It is intellectually dishonest to lump venture investors with hedge fund and buy-out investors.” The way Ferreira sees it, venture investors help develop start-ups, which fuel innovation and create jobs. In fact, he goes as far as to say that he’d “grant additional tax breaks and subsidies to the VC industry.” This, he states, would help spread innovation beyond the current VC hubs of Silicon Valley, New York, Washington, D.C., and Boston.

So, why should we care? Let’s face it: It’s easy for most of us to blindly support taxing a bunch of absurdly rich guys. But it’s not quite that simple. First, these aren’t the people who tanked the economy with deceptive trading practices. VCs are the folks who can most readily fuel the next world-changing idea (even, perhaps, your world-changing idea). This altered tax structure will have a tremendous effect on their business.

A quick scenario: If the new tax is enacted, the common logic is that VCs won’t eat the added cost; they’ll simply pass it along to their investors. Theoretically, this will cause fewer people to gamble on the VC game due to the increased cost, thereby leading to the shuttering of less-proven VC shops, which means that fewer ideas get funded. If you’re hoping to start a company, what sounds like an obscure issue suddenly hits home in a few quick steps.

So what’s your take? As Fred Wilson admits, VCs “are among the most highly compensated people in the world.” Do they have a moral responsibility to accept the higher tax load? Or will the increased hurdle only end up making it harder for good ideas to find the funding they need? Should VCs be granted an exception from the tax hike? It’s not a cut and dry question, to be sure. But as people who care about building the companies that define the future, it’s one about which we need to have an opinion.