Time for PE and VC to pay up

Private equity and venture capital professionals in the US are a step closer to being taxed at a much higher rate on their income.

Democratic senators earlier this week introduced a new bill that aims to close the carried interest loophole, setting the stage for top earners to see their tax rates on investment gains roughly double.

The National Venture Capital Association and the American Investment Council, the lobbying groups for the VC and PE industries, have denounced the proposed hikes. But that doesn't change the reality: Investors should easily be able to sustain the higher tax burden, in part because they've never had more money in their coffers.

North American venture capital has beat out every competing asset class in three-year IRR performance, at 18.51%, according to PitchBook data. And North American private equity ranked second at 15.09%, besting real estate, secondaries, private debt and more. Plus, private investors collectively had about $1.5 trillion in dry powder at the end of 2019, according to reports. A higher tax rate won't keep them from deploying capital, despite the NVCA's claims that higher taxes will disincentivize long-term investments.

After all, firms have contractual obligations with limited partners to deploy their money. If anything, the threat of a higher tax rate should motivate general partners to do everything to maximize profits.

Investors knew this change was coming. Even before the latest legislation was unveiled, tax fund advisers in the private equity industry expected a hike in capital gains taxes and began advising clients to be prepared.

"We know what's going to change," said CohnReznick managing principal Jeremy Swan, referring to the hike in capital gains. "We just don't know how bad it's going to be."

Critics of private equity have lobbied for years to increase the capital gains tax rate for fund managers. And calls for change intensified after President Joe Biden announced a provision to end the loophole as part of his "American Families Plan," a $1.8 trillion spending package that seeks to expand access to childcare, education and more.

The Democrats' new tax measure would raise roughly $15 billion over the next decade. But those who have decried Wall Street greed have seized on the bill's symbolic nature, pointing to the country's widening income inequality. Sens. Joe Manchin (D-W.Va.), Tammy Baldwin (D-Wis.) and Sherrod Brown (D-Ohio) introduced the legislation, which has a similar version circulating in the House.

"The carried interest loophole is yet another example of Wall Street executives exploiting our tax code to pad their pockets rather than invest in workers and Main Street," Brown said in a statement.

Dubbed the Carried Interest Fairness Act, the legislation would raise the carried interest tax for individuals to 39.6%, the top proposed federal income tax rate. Current tax laws treat carried interest profits as long-term capital gains, which can be as low as 20%. To put that in perspective, a single filer making about $41,000 annually pays 22% in federal income tax. Not exactly a balanced system.

Yet when Biden introduced his plan, it was unclear whether he could garner support from Republicans and Democrats, many of whom have deep ties to venture capital and private equity. Doing away with carried interest tax treatment has been floated for years but never received enough support in Congress to pass. Former President Donald Trump campaigned to end the loophole before ultimately agreeing to leave it out of tax cuts passed in 2017.

But circumstances have changed with Democrats in control of the presidency and Congress. The good news for general partners: Biden has signaled a willingness to negotiate on tax rates, leaving hope that a compromise might be reached.

"I expect it might be likely that you find some sort of middle ground there, you know, maybe you're talking about 25%, 28% raise, something like that, as opposed to going all the way to 39.6%," said Robert Richardt, a CPA and partner at CohnReznick.

Some venture capitalists have signaled support for the principle of a tax hike. Khosla Ventures founder Vinod Khosla said last month that "sharing the benefits of capitalism is not terrible."

Make no mistake. Change is coming.

Biden has also proposed raising the corporate tax rate to 28% from the current 21%, and the top income tax rate to 39.6% for individuals earning more than $400,000 annually. That would cut into the income of fund managers, not to mention publicly traded buyout shops such as Blackstone, KKR, The Carlyle Group and Apollo Global Management. But that hasn't made firms jittery. At least not yet.

"I haven't seen a lot of current changes in behavior," Richardt said. "And it's a little bit difficult at this point, with a lack of clarity on exactly what the changes are going to be."

Featured image by Scott Olson/Getty Images