Are entrepreneurs exploiting a tax loophole?

December 8, 2010, 9:03 PM UTC

Whenever I’ve argued in support of changing the tax treatment of carried interest from capital gains to ordinary income, someone has replied with: “Gains from founders stock is similar to carried interest, in that founders don’t put up actual cash for their shares. They just put in time and effort. Therefore carried interest also can be considered a capital gain.”

My stock reply has been to acknowledge the similarity, even though many founders technically will invest something for their stock (e.g., $0.00001 per share). Then I warn against making the argument:

“You are right,” I say. “But consistency (for me) actually would dictate that founders stock be treated as ordinary income, rather than dictating that carried interest retain its capital gains status. That may not be a path you want me to pursue…”

Well, Victor Fleischer apparently is going there. For the uninitiated, Fleischer is the U Colorado professor (temporarily hanging out at NYU) who kicked off the carried interest kerfuffle with a paper titled “2 and 20.”

The New York Post reports that Fleischer is nearing completion on a paper that would recommend changing the tax treatment on founders stock from capital gains to ordinary income. He estimates that closing the “loophole” would generate around $100 billion in additional federal tax revenue per year.

As I have told people for years, I struggle with this one. Consistency in logic and argument is important, but it also can have its limits. At times I am willing to repeat Walt Whitman’s famous phrase: “Do I contradict myself? Very well then I contradict myself.”

The issue here is whether changing this tax break would significantly dissuade potential entrepreneurs from hanging their own shingles. My gut feeling is that it would, and perhaps in great numbers. There are many factors that contribute to the creation of an entrepreneur — including passion for the product and a desire to be one’s own boss — but the prospect of future riches is right up there. Given how few entrepreneurs actually succeed, it would seem counterproductive to lighten the pot of gold.

This stands in contrast to my feelings on carried interest, as not a single significant VC or PE pro has ever promised to change careers if that tax treatment were altered.

I’m still working through this in my mind, and am interested in your thoughts. Not thoughts based on self-interest, but ones based on reason. Maybe the solution is some sort of hybrid structure, where the first several million dollars are taxed as capital gains and anything above that becomes ordinary income. Maybe something else.