How Will Closing the ‘Carried Interest’ and ‘Founder’s Stock’ Loopholes Affect New York Tech?

loophole 0 How Will Closing the Carried Interest and Founders Stock Loopholes Affect New York Tech?One, two, the White House’s coming for you. While you were busy counting the days until Foursquare’s IPO, the good folks of Washington have been fretting over the debt crisis. Mayhap you’ve heard of it? Well, techies better start paying attention because it looks like it could hit close to home.

At issue are two tax loopholes, “carried interest” and “founder’s stock.” President Obama wants to close “carried interest” tax, estimating that it could raise $20 billion over the next decade.  Congressional Republicans refuse. In The New York Times, Nicholas Kristoff says “carried interest” wins the grand prize for “Most Unconscionable Tax Loophole,” adding, “This loophole has nothing to do with creating jobs and everything to do with protecting some of America’s wealthiest financiers.” While he’s at it, he’d like to do away with the loophole for founder’s stock too.

NetNet’s John Carney has a very different take on founder’s stock, writing, “It’s not some unique bizarre scandalous loophole in the tax code. It actually coheres quite well with the way we tax a lot of other returns on entrepreneurial activity.”

Considering Union Square Ventures’ stake in Zynga’s upcoming IPO and the number of New York start-ups counting down to their S-1 filing, here’s what you need to know.

As Mr. Kristoff points out, combined the loopholes subject hedge fund managers’ performance bonuses, typically 20 percent or more of profits, carried interests or “the profit-based quasi-bonus that VC partners earn from their investments,” and founder’s stock, the shares founders own in companies they started, to lower capital gains tax (15 percent if it’s held longterm) as opposed to higher personal income tax of 35 percent.  (Capital gains are the growth in the value of an investment that’s not realized until an asset is sold):

This carried interest loophole benefits managers of financial partnerships such as hedge funds, private equity funds, venture capital funds and real estate funds — who are among the highest-paid people in the world. John Paulson, a hedge fund manager in New York City, made $4.9 billion last year, top of the chart for hedge fund managers, according to AR Magazine, which follows hedge funds.

. . . This tax loophole is also intellectually vacuous. The performance fee is a return on the manager’s labor, not his or her capital, so there’s no reason to give it preferential capital gains treatment.

. . . One important proposal has to do with founder’s stock, the shares people own in companies they found. Professor Fleischer has written an interesting paper persuasively arguing that founder’s stock is hugely undertaxed. It, too, is essentially a return on labor, not capital, and shouldn’t benefit from the low capital gains rate.

We’ll leave aside, for a moment, the vast difference between the returns pocketed by a hedge funder and the average venture capitalist or founder and get to Mr. Carney’s rebuttal. His read is that its the founder’s labor that creates capital, making the case for continuing to levy the lower capital gains tax since that’s the same way hedge funds are treated. (Admittedly, somewhat circuitous argument):

When explaining this to people around New York City, I often find it useful to point to the ownership stakes in venture capital funded tech start-ups owned by founders. The labor of the founders is often what makes the value of these companies grow. But the tax code doesn’t treat these gains as ordinary income—it treats them as capital gains.

Founder’s stock, in that way, is just like the “carried interest” of hedge fund managers. It’s value that is created by the work of its owner but gets treated like capital.

With budget talks getting desperate, it looks like it’s time to pick a side.