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What are some arguments for taxing carried interest as ordinary income, but not taxing founder's equity the same way?

  • Let's say I start a company and sell 80% of it to my investors at a million-dollar post-money valuation. A few years later, we sell the company for $2 million. Normally, I'd pay capital gains on this income. But apparently if I classify my activity as private equity or venture capital, I should pay ordinary income taxes on the money. What are some good defenses for taxing private equity investors differently (or exempting non-PE founders from income taxes, depending on how you'd like to look at it)? It seems perverse to argue that one should pay lower taxes for investing cash rather than effort—that seems like a policy that would benefit the already rich, rather than those who are still trying to get rich.

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    The company founder is in the business of making widgets or websites or something, while the typical investor is in the business of making more money.  A founder is usually focused on his one project while an investor is typically touching multiple projects at one time. Outside investors are a wonderful grease to bring concepts to scale, but if you have ever been on the founder's end of the table VC's don't give that stuff away for free.  They, rightfully so, research, vete and then back the founders that they believe will generate the greatest return for them because that is the business they are in.  There are a lot more founders that take significant risks that never pay off than there are ones who find investors and succeed.  Compared to VC's that have their failures but overall they have to have enough winners to more than offset the losers or else they won't be in the VC business for long. I look at the tax advantages afforded founders as just an additional carrot to get them to take the out-sized risks.

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The question you were asking confused some concepts. Private equity funds have different tax regimes and can go very complex. PE funds can invest all sorts of activities including stocks, operational business, real estate, and etc., which may cause different tax treatments. Based on your question, I would assume your fund only invest in stocks. Profit (Loss) on stocks is capital, and if you hold it over than 1 year, it will be long term, and otherwise be short term. The capital treatment gives you a preferential tax rate. However, this only applies if you are a limited partner and would change if you are general partner of the PE funds. If you are a GP, the capital treatment will become ordinary. The legitimate thinking is that you are an owner and paying yourself a “decent “compensation which should be considered as ordinary and taxed as the same rate as your other income.

Shells Xie

Your question is internally confused.  The only low tax rate we're talking about is long-term capital gains, which as a policy matter is currently taxed at rates below ordinary income taxes.  So if you sell your stock after more than a year, you will pay LT cap gains tax (ie lower taxes).  If your fellow investors sell their stock after holding more than a year, they too will pay LT cap gains (ie lower) taxes instead of ord income taxes.  The policy question asked by most people is whether carried interest (ie, the portion of any capital gains paid to the PE managers) should be taxed as capital gains or as ord income.

Anonymous

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