The Solution to the “Carried Interest” Problem

The L.A. Times’ “Money & Co.” has a piece on the carried interest loophole for Private Equity (including V.C.).  Frankly, almost nobody really understands this issue outside the industry and our advisors, but people outside of our industry are going to be reading all kinds of nonsense populist propaganda saying “soak the bastards!” as well as our own industry’s propaganda of “God bless America and profit and mom and innovation and apple pie!”  (Incidentally, it is true that we VCs are different qualitatively from private equity buyout guys — and there are arguments for why we should be treated differently — but everything I’m about to say applies pretty equally to any kind of limited partnership.)  None of the propaganda and hype, however, actually helps us get to the understanding needed to solve this problem in a way that is both equitable and helpful to the Republic.

If you’re not more than merely superficially familiar with this policy issue, let me give you a relatively objective overview of the three elements: LPs, taxation, and liability.

LPs (Partnerships): The LP (limited partnership) structure is a way to recognize formally and legally the age-old practice of having a “silent partner” in your business.  Joe wants to open a factory, but doesn’t have the money; Bob has money but doesn’t know from factories.  Joe and Bob go in, Joe contributes knowledge and work, Bob contributes money.  They agree to split the profit 33/67, even though Joe doesn’t put in actual dollars.  (Win-win: Joe bootstraps up from penury and Bob fattens up without working too much.  It’s been going on at least since the Venetians organized expedetions as “commendas” in the 1300s.)  Now, on the surface, this SOUNDS a lot like the case where Joe starts a corporation and sells 2/3 of it to Bob for the money, but there’s an important difference: taxation.

Taxation: In the corporation (Bob as “shareholder”) model, the profits will get “doubly” taxed at the corporate level first (income tax), then get taxed at the individual level (dividends, or maybe cap gains).  In the LP case (Bob as “silent partner”) model), the profits are NOT taxed at the partnership level — instead, they’re “passed-through” and treated as though each partner did the activity directly (or his share thereof).  You might immediately note that for most all businesses, this would seem to make the LP structure a lot more attractive — so what gives?  What’s the tradeoff?  It’s liability.

Liability: In a corporation, the managers and shareholders are generally NOT liable for the debts of the corporation (except for blatant malfeasance).  (This also breaks down in small companies because banks basically ^!@#$ you over and won’t finance you without personal guarantees.  But the bigger the corp, with more negotiating power, the more true this “limited liability” is.)  In a partnership, in contrast, there must always be at least one “general partner:” a person who controls and is personally liable for the partnership, with unlimited liability.  (The “limited liability” of an LP applies only to the silent, or “limited” partner, who must not exercise control.)  Hence, the essential tradeoff between these structures has to do with whether the controlling manager is personally liable — and frankly, when faced with the possibility of unlimited personal liability for a risky business, paying a “double taxation” rate starts to seem not so bad.

That’s it.  That’s the historical reason for this “loophole,” and frankly it’s pretty understandable when broken down that way.  If you want to take advantage of the legal fiction called a “corporation,” and its made-up, state-conferred advantages including limited liability, you pay more taxes.  If you are willing to associate personal control with personal unlimited liability, you get to dodge them.  You can argue if the tradeoff is right, but it’s a tradeoff.


The problem, today, is that the tradeoff is completely disrespected.  A new corporate form that has caught on since the 1970s, the LLC (Limited Liability Company), allows you to create a legal “person” with the same tax treatment as a partnership, but without the personal liability for any individual.  Hence, any LP whose managers have half a brain today is set up like this:

Acme, LP.  Limited Partner (investor): Rich Dude.  General Partner (manager, liable): Acme Managment, LLC.

Acme Management, LLC.  Owner and Manager: Skilled Guy.

As a result, you still have Rich Dude and Skilled Guy acting out the roles of silent (limited) partner and managing (general) partner, but Skilled Guy has now inserted an LLC “shield” in the middle to protect himself from personal liability. Since that LLC is also a “passthrough” entity, the whole structure is transparent for tax reasons.  As a result, Skilled Guy’s profit distributions (“carried interest”) get the favorable tax treatment, even though he doesn’t have to make the tax vs. liability tradeoff.

So, to me, the answer is simple.  That kind of structure should not be permitted to receive the same tax treatment as one in which the general partner is a “true,” personally liable, general partner.

My proposal for legislation:

  • Carried interest gets passthrough tax treatment for individual general partners IF there is true bona-fide personal liability risk borne for the partnership.
  • Carried interest OTHERWISE can’t be passed-through.  It must be taxed as income either at the intermediate LLC level or the personal level.
  • All existing partnerships have a 3-year window from today in which to elect to recharacterize their intermediate entities to enable true personal liability for passthrough treatment without penalty and with “shall-issue” consent etc. from the IRS and states (but are not required to do so).
  • The IRS will be empowered to seek the “substance” of convoluted structures to prevent tomfoolery.

Frankly, this is probably heresy in the VC world.  Our cross-town neighbors at OVP seem to think that their carry is an “asset … which we contribute cash to own” which amounts to a pretty tortured reading of the flow of dollars into an LP.  The National Venture Capital Association has its own pretzel logic that addresses how wonderful, beneficial, good-looking, and high in anti-oxidants we VCs are, but doesn’t address anything about the fundamental tradeoff itself.

It’s easy to see why our brethren knee-jerk against carry taxation.  For every $1 M in expected value, getting LT cap gains rates instead of top marginal rates means an extra $200k-ish, which is real cheddar even to big-shots.  But that’s fine: if you want to preserve your pass-through prerogative, you should be able to, just like every other general partner of every partnership could prior to the widespread adoption of LLC passthrough-sans-liabiltiy forms: by taking personal liability for the entity’s obligations.

So, to be clear: VC most certainly is a valuable and unique part of our economy; VC is absolutely and necessarily distinct from buyout and hedge funds, and importantly, there is a longstanding historical precedent and clear legal tradeoff justifying differential treatment of carried interest for taxation purposes.  But that tradeoff has now been rendered obsolete, and should be put back into whack — and it’s quite possible to do so in an equitable and rational way.

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