Jon: Tax loopholes, the unfair tax loopholes that venture capitalists get.
Jon: So this podcast is going to be a little bit different. We're going to talk about some behind the scenes things of how Uncle Sam treats venture capitalists. So if you're looking for more startup advice, this one is not that episode.
Peter: But if you're following politics in the last few weeks, then you've heard about the carried interest loophole quote. And Coke is not actually a loophole which.
Jon: Has been stressing Peter out. So basically that the.
Jon: Topic is, is that if you look at a VC as a business now, a large chunk of their quote unquote revenue is not taxed at the same revenue as a Codebase is right or the same revenue that I take home. They basically get capital gains tax rates immediately in their pocket where code base I have to pay regular corporate taxes.
Jon: If if the business if the business shows a profit and I have to when I get personally paid, I have to pay regular, you know, income tax. Whereas when Peter gets paid from Kerry, there's this loophole where he gets a much better rate.
Jon: So this is something that's been trending on NPR. So let's talk about it. And it's.
Peter: Not just NPR has been everywhere because that was going to be in the end inflation bill or whatever they're calling it.
Jon: And they're using it to to to fight global warming and things like that. Yeah, as well. That is.
Peter: Okay, So here's the context.
Jon: This is the you can tell Peter that let's get one hit his heart.
Peter: Hit my pocketbook now, but let's set the stage and provide the context. Okay. So carried interest was carried interest. So a venture fund, a private equity fund, a hedge fund or real estate fund, anything that has an LP, limited partnership and general partnership structure? Well, I mean, not any of them, but most of them are going to have two forms of compensation from their investors.
Peter: One is management fees. And those management fees are used to pay day to day operations, salaries, overhead, office space, like all that general stuff. And industry standard is about 2%. So if I have a $100 million fund, then I'm paying 2% of that $100 million every year for so many years. And that's defined usually like 3 to 5.
Peter: And then it will typically decline or it'll be a like percentage of total dollars invested and we won't get on the nuances. Their point is you're pulling like roughly $2 million in fee and that $2 million is meant to cover, like I said, like overhead salaries, etc.. That's not what's up to debate. What's up to debate is the other piece, which is the performance fees.
Peter: So the industry standard is about 20%. Some go as high as 30%, some are lower, like 15 to 10%, but it's 20% of the profits of the fund. So if I invest $100 million and I in those investments perform well and they generate, let's call it like $300 million of returns, then I return the $100 million. I'm left with 200 million, and I'm going to split that 8020 with my investors.
Peter: So I'm going to get I'm going to return 160 million. So a total of 260 million return to them. And I'm going to pocket $40 million. And the way that the tax code is written, that $40 million gets treated as capital gains, not as ordinary income. Now, in other areas, right, like if I'm a sales rep and I sell some product and I get paid a bonus or a commission for selling that product, I'm not taxed on that.
Peter: A capital gains, I'm tax on that as ordinary income. And so there's this debate that's like, hey, this is a performance fee. It's kind of similar to like, you know, sales, right? Like a commission. You're getting paid to do your job that should be taxed as ordinary income, not as capital gains and private equity. And venture investors and hedge funds say, well, but, you know, there's some risk and we're not going to get paid that it's you know, it's kind of a piece of the overall investment.
Peter: Yes, we're getting compensated for like our work. But, you know, there's there's some risk there to it to.
Jon: Okay, I get taxed on my bonuses. So that's.
Jon: And a bonus is risk. So whatever it is, it should be similar.
Peter: Yeah, and maybe it should, but and that's the whole debate. Right. Okay. Is that and that keeps coming up. Democrats and Republicans have brought it up again and again and again. And for whatever, like every couple of years it comes up every couple of years. For whatever reason, it gets axed out of the bill. The last time, as you know, the senator from Arizona, that kicked it out.
Peter: So, yeah, look, I think I think there are good arguments for why it should. It's it's like it shouldn't exist.
Peter: I think there are good arguments for maybe why it should exist. Right. I think if you are I mean, if you play the math forward, right, if you're a hedge fund manager and you're generating hundreds of millions of dollars of carried interest right. There's and you have to pay either 25% or 40 to 50% taxes on that. Well, I mean, that's a difference of 25 million upwards of $25 million, right, Per 100 million.
Peter: That's that's a that's a lot of money. But the flipside is you're also pocketing 50 million bucks.
Peter: You're not doing too bad, Right? So do you need that extra $25 million or.
Jon: Not Those we just flip it. The rest of us bonuses are taxed the same as how how fund managers get paid with their carried interest.
Peter: Well, I mean, the libertarian in me would be okay with that because I think, you know, that's.
Peter: Lower taxes but are better.
Jon: But are you a libertarian?
Peter: I definitely been more libertarian.
Peter: But the point being is like, well, we're not going to change that. That's not realistically going to happen. So what we should do is.
Peter: We should make it consistent. Here's the thing. On the flip side, if you're a venture investor or let's say you're a brand new venture investor, right? Let's say you're maybe like a minority emerging and manager, venture investor, right? First fund, whatever. It's very unlikely that you're going to be able to raise a very large fund, right? So maybe your first fund's like $10 million, right?
Peter: You're a great investor, but you know, maybe you're a minority, maybe you're emerging manager, like whatever, Like the cards are stacked against you. Like it's harder to raise that first fund and your second fund and maybe your third fund, right? So you've got these relatively small funds and a $10 million fund. You might be pulling a couple of hundred thousand dollars in management fees per year, and with that, a couple of hundred thousand dollars.
Peter: You got to pay your salary. You got to pay your analyst salary, right? If you have one, you got to pay your legal bills, your accounting bills like your office, your overhead, your travel. You're like I mean, you're probably like a good fund manager. Probably left a job where he or she was making 100, 150,000, right minimum. Maybe more than that, 200, 250.
Peter: And now they're going to take like a massive pay cut to set up this fund. And they do that because they're hoping on the back end that their investments will perform well and they'll get this this carried interest and that will make up for like the income differential. And so it's it's super meaningful. Right. And, you know, let's say they take that 10 million and they just have a, you know, a killer fund and return like five x that fund, that's $40 million.
Peter: They're going to split that 8020. So that's $8 million coming back to them, while like $8 million sounds pretty good. But if you got to cut half of that out in taxes, now you're talking $4 million and then you're taking that $4 million and spreading it out over the course of ten years. So, you know, really, it's not that much money at the end of the day.
Peter: Right. And if the returns aren't that good, Right. You just take those numbers down even more so that the thing there is and there's some risk. Right. They don't know that they're actually going to get that and it's going to take them like 10 to 15 years to generate that kind of return. So the challenge there is that if you're an emerging manager, you're, you know, an A or a minority, you might look at this and be like, you know, I've got this really great job today, or I'm making like 200, $250,000 a year because I work at Google as an engineer or a product manager or whatever.
Peter: And if I leave and I start this other fund, I might be making, I'm going to like have to go from 250 to 300000, whatever, a year to like 75.
Peter: And then on the back end, like.
Peter: In the back end, you know, maybe if I'm successful, I'm going to get a few million bucks, but it's going to take 15 years to get there and look like I'm not saying like feel sorry for them.
Jon: I feel sorry for you.
Peter: But here's the problem. Here's the problem. If the emerging manager, especially if they're a minority, they look at that and they say, you know what, that's way too risky. I'm not going to do it. Then what happens? We end up we don't we don't end up with emerging managers, particularly minorities and minorities. And women are more likely. They're 50%.
Peter: They're to more likely 30, not 50. Women and minorities are twice as likely to invest in other minorities, and women are in businesses than than white men. So you think that. And so if we.
Jon: Don't think that minorities and female fund managers are not going to even become fund managers because of the tax rate.
Peter: I think there will be fewer of them.
Jon: Because of the tax rate. They're going to say, when I look at everything, this tax rate is the one thing that's going to make ten, 20, 30, 40% of the fallout potentially. Really?
Peter: I don't know. I think it's one of those things that could, you know.
Peter: It's a decent, attentive. And any time you have a disincentive, like fewer people are going to do it.
Jon: So if we pull out your confirmation bias, your main thesis that I can wrap my head around is you feel like this adversely affects minority and females that are considered.
Peter: An emerging manager and just emerging managers generally.
Jon: Just emerging managers in general, and especially these these other representation in minorities or ethnicities. Sure.
Jon: I'm not in deep enough to think about it, but I do see some parallels. You know, is this a bonus like income or is this like a CEO selling their company that gets taxed at capital gains?
Peter: Yeah, and I agree with you. Like, I think it's nuanced. It's definitely gray. I'm just saying, like, there are two ways to look at it, right? There's pros and cons. There's like and I think at the end of the day, if if the return is our bigger returns on the back end, it's going to incentivize more people to enter the space.
Peter: Right. And if you cut those back, they're going to be fewer people that I mean, that is going to look going to be like I don't know if it's worth it. I'm going to maybe do something else.
Jon: Would keep my enterprise sales job.
Peter: Yeah. Or maybe I'm going to start a company or I'm going to, you know, okay, I'm going to do something else.
Peter: And and then what I think that does is it has a risk of perpetuating this like the rich once they've gotten there. Like they don't care, right? I mean, they care, but like, whether or not we take $25 million out of their pocket or $50 million out of their pocket, they're still pocketing at least $50 million. They're going to be okay, Right.
Peter: Like nobody's feeling bad for them. Right. And and at that level, nobody's, like, disincentivized to not keep doing it. Okay.
Jon: I think this is going to be those moments. You've said your piece. Okay. The audience decide. I don't have I'm not a deep enough to understand. I do think there should be consistency across the board, though. Whatever it is, if it's income. Yeah, then what is income a sign of business and income? Is that my confirmation bias? Just like you've got your confirmation bias of how you're affected?
Jon: Sure. All right. Well, well.
Peter: And keep in mind, I'm not I know that I just spent a bunch of time talking about like how it could negatively impact staff. I'm also not like arguing super hard that it should be retained the way it is.
Jon: What do you think it'll happen? My guess is it'll probably get wiped out just like every other bill because it's a small aspect.
Peter: Larger. Well, it's already been. It's already been taken out.
Peter: It's already been.
Jon: Takes out of me a point for this year. Yeah. It's going to come up again.
Peter: It's going to come back up again and it will probably stay because, because the people that are making 50 million, 100 million, whatever. Right. They're you know, they're like, hey, senator, whatever you if you got carried interest, I've got $25 million less that I can donate to your campaign. Okay. So, yeah, your call. Do what you want. Okay.
Peter: All right. But just keep in mind, like you're tightening my belt so there's just less to go around, which, you know.
Jon: I wish you all had that.
Peter: I think that is why it keeps getting. It gets thrown in and then taken out and taken out because, you know, the senators and the congressmen and women that aren't getting it are like, this is not fair and we need consistency. Yeah, right. And those that are kind of like, well, if you want my vote.
Jon: And if you're trying to become a you, this is something that's going to be very relevant.
Peter: for sure. You have to understand this. Yeah.
Jon: Okay. So of aspiring because listen to Peter. This podcast was for you.
Peter: But I think what is interesting is let's say that they do take it out. I guarantee you that somebody will figure out another like way around it, okay?
Jon: They'll just start offshoring all their cash.
Jon: Up set up funds in other countries.
Peter: I mean, like so many have already been doing that.
Jon: Is that a big trend? Right.
Peter: Offshore accounts.
Jon: Are there Offshore, I.
Peter: Would say like a lot I mean, I don't know the numbers, but it would not surprise me if the majority of venture funds, private equity funds and hedge funds are are set up offshore.
Jon: Is your set up offshore?
Peter: I can't disclose that sort of thing.
Jon: They're crazy. Taxes. Well, anyways, yeah. If you want to learn more, go to venture capital firm where you can like and subscribe and follow us and anywhere you want to follow us on TikTok and see our our sexy dances. We are there.
Peter: All right, guys. We are.
Jon: All right. We'll see you guys for the next episode. Venture capital out of them. Make sure you give us a six star review, please. And you can now leave reviews on Spotify. That's the new thing that happened in the last week or two.
Peter: I think. Comment. Subscribe. Like us.
Jon: All right. See you guys soon. Talk to you later.
