TAX NEWS - June 2010

US Tax: A Tax too far

Even as their industry slowly rebounds from the misery that began with the 2008 financial meltdown, venture capitalists have a new worry—a push in Congress to impose more taxes on them.

Last month, the House passed a bill that venture capitalists said would hamper incentives to invest in early-stage companies. The bill, they said, would treat them the same way as oil or gold speculators. On Tuesday, Senate Democrats unveiled a modified version of the measure, which reduced some of the sting, but would still lead to a higher tax bill.

At issue is the tax rate on carried interest. Currently, the amount of money partners in a venture capital firm take as compensation is taxed at the 15 percent capital gains rate, not the higher income rate, which can reach 35 percent.

The House voted 215 to 204, largely along party lines, to tax up to 75 percent of venture capitalists' compensation instead of as capital gains. According to the House plan, the government would tax 50 percent of this compensation as ordinary income in 2011 through 2013. Afterward, 75 percent of carried interest would be taxed as ordinary income with only 25 percent as capital gains.

The Senate alternative, offered by Finance Committee Chairman Max Baucus, would initially set a 50 percent ordinary income and 50 percent capital gains split, followed in 2013 by a 65 percent ordinary income and 35 percent capital gains division.

Before Baucus revealed details of his alternative, the reaction from the venture capital community was understandably hostile.

"If this bill is signed into law, Congress should expect a further decline of venture investment over time, a move away from seed and early-stage investment, and less innovation and job creation for our country," Mark Heesen, president of the National Venture Capital Association, said about the House legislation.

On Tuesday, Heesen wrote a blog post that said the organization wouldn't comment because the Senate had yet to act. "Do not assume based on press or other reports that any proposals are final until a bill is signed into law," he wrote.

But one prominent venture capitalist was unimpressed by the Senate's action.

"As the rest of the world welcomes venture capital with open arms, the U.S. is pushing us away," wrote Draper Fisher Jurvetson co-founder Tim Draper in an email exchange with Portfolio.com. "Doesn't anyone in Congress see that by increasing taxes and regulations on businesses that create wealth and jobs, they are driving innovation away to other countries that have more competitive environments?"

The impetus for the tax hike is obvious—the government needs money. Democratic lawmakers think they can raise anywhere from $14 billion (the Baucus bill) to $17.5 billion (the House-passed version), though any savings would be used to pay for tax breaks for retailers and more unemployment benefits.

In fact, little of the debate so far has been around the carried-interest tax issue and instead has focused on jobs.

"We are talking about people who have worked, want to work, and will work again. These are our neighbors. And they need our help," Baucus said Tuesday on the Senate floor. The senator from Montana never mentioned venture capitalists or carried interest.

Advocates for the tax change argue it's all about fairness. Victor Fleisher, a University of Colorado professor whose research helped spark the move in favor of the tax, told the New York Times the money that venture capitalists or hedge fund managers make shouldn't be treated differently than money other people make for a simple day's work.

"They're being paid a fee for a service, so it's fair that they would pay the same rates as others who perform services," Fleischer said.

The effort to raise these taxes comes as a blow to an industry in flux. By some measures—the initial public offering and merger markets for startup companies—things are looking up. During the first quarter of this year, nine venture-backed IPOs took place to make it the best quarter since 2007, according to a Thomson Reuters survey for the NVCA. During that period, there were 31 mergers and acquisitions, worth an average of $180.2 million, an increase of 21 percent over 2009.

But those positive-trending figures can't erase the fact that 2008 and 2009 were very bad years for venture capitalists. "The exit activity in first quarter of 2010 has engendered a cautious optimism within the venture capital industry," Heesen said. "It is premature to suggest we have permanently turned the corner, but that corner is in sight and within reach as long as we can continue this positive upwards trajectory over the next consecutive quarters."

Likewise, venture capitalists loosened their own wallets in the first quarter compared with the same time last year. They invested $4.7 billion in 681 deals in the first quarter compared with $3.4 billion in 635 deals in the previous year's first quarter.

While that's good news, it's not exactly a roaring time, and few would tell you it is. In fact, most venture capitalists expect their industry to contract in the near future.

"There is no question that the industry is shrinking and that folks are having a hard time raising money," said Vantage Point Venture Partners CEO Alan Salzman. "Lots of people have noticed it. The data is pretty clear."

And critics have said that far from encouraging job creation, if Congress passes a law to significantly change how carried interest is treated, the jobs created through venture capital would be lost.

"Our venture capital system is the envy of the global economy. Over the past few decades, it has spawned entire industries—from semiconductors and the Internet to biotech and now clean technology," Michael Greeley and Terry McGuire wrote this week in the Boston Herald. "Without the capital gains incentive, the risk-reward ratio for venture investors looks a lot different. Far from stoking job creation, the result would be an anti-stimulus. Worst of all, if venture capital investment disappears, no other asset class would fill the void."