September 18, 2007
AEI Carried Interest Debate
Posted by Victor Fleischer

I'm heading down to DC in the morning for a debate on carried interest hosted by the American Enterprise Institute.   The event is at 2 pm; details here

The carried interest buzz today was about the National Venture Capital Association breaking ranks with the private equity industry by suggesting that legislation, if enacted, should carve a distinction between the buyout industry and the venture industry.  It was suggested that this could be accomplished by retaining the status quo for funds that invest in new companies.  But even if that were a good idea--and I remain unconvinced that VCs need a tax subsidy--I don't understand how it would work mechanically. 

For example, when a buyout fund buys a division of an existing public company, those assets go into a new corporation managed by the fund.  Does that count as a new corporation?  Or an old one?  What about start-ups that struggle along with angel financing for a few years and then get venture financing.  Newco or Oldco?  Limiting the capital gains preference to companies held for more than 4 years excludes "buy it and flip it" deals, but also creates a greater lock-in effect.  I'm struggling to think of a way to distinguish between venture-funded portfolio companies and buyout-funded portfolio companies that would work.  One possibility, I suppose, is to revitalize section 1202, which reduces the capital gains rate for investments in small business corporations, measured by the size of the assets of the firm at the time of the investment.  This could be added into the Levin bill as an exception to the rule stating that investment partnership services income is treated as ordinary income. 

The best tax policy for encouraging entrepreneurship is to have a broad tax base with low rates.  The carried interest bill broadens the base and might stave off a hike in the top marginal rates.  Even assuming we want to use the tax code to encourage entrepreneurship, carving out venture capital from the Levin bill isn't the way to go about it. 

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