Proposed Changes To Carried Interest Would Negatively Impact Diversity In Venture Capital

In his must-read new book, Post Corona, Scott Galloway calls Section 1202 a tax law that “is nothing but a transfer of wealth from other taxpayers to venture capitalists.”  In my previous article on how this section of the U.S. Tax Code can actually increase diversity in VC, I address how it’s actually not §1202 that’s a problem.

It’s the tax treatment of carried interest. 

If you want to pick on a tax law that is a simple “transfer of wealth from other taxpayers to venture capitalists,” look no further than the historical treatment of carried interest. Carried interest is a venture capital, private equity, or hedge fund investor’s cut of the profits from their investments, and it is taxed as capital gains instead of as ordinary income. 

Right now, the capital gains tax treatment of carried interest has a far greater impact on billionaire fund managers than Section 1202. On the one hand, a change to the carried interest tax treatment is needed; billionaires need to pay their fair share of taxes, even if they head job-creating companies. On the other hand, Congress should be careful not to treat fledgling venture capital firms the same way they do established private equity investors. Diversity is coming from these VC funds, not established firms.

The greatest total dollar impact of a change to carried interest will be to billionaires – large asset managers like Steve Schwartzman, Larry Fink, and Ray Dalio, who have made billions on carried interest, paying 20% capital gains tax on their primary form of compensation instead of the 91% tax they would have paid on ordinary income in the 1950s or the 37% tax they pay on ordinary income today.   

Dalio and Schwartzman have excellent biographies that every fund manager should read. Entrepreneurship is hard – especially at the beginning. But that’s not unique to them or anyone else. And they’ve paid record-low tax rates compared to the uber-wealthy of previous generations. Since the 1960s, the U.S. has been subsidizing its current lifestyle by taxing the poor and the next generation unfairly so that billionaires can be bigger billionaires. As a result, the U.S. has a $3 Trillion deficit – and it’s only getting worse due to COVID.

So, yes, a change does need to be made to the tax treatment of carried interest. However, Congress should consider the impact of changes to Carried Interest on diversity and give a 0% capital gains tax break on the first $10 million – as Section 1202 does – and then tax the rest as ordinary income. 

This would ensure that Jesse Draper of Halogen Ventures is not treated in the same way as Steve Schwartzman of Blackstone. Because Jesse and her principals and associates are building a brand new firm and should be able to use that initial carried interest from their early investment wins to continue to grow, hire more talent, and invest in more underrepresented founders at the pre-seed, seed, and Series A stages.

Fund managers raising a $10MM first-time venture capital fund are not the same as billionaire buyout or hedge fund managers with a $1B first-time buyout or hedge fund. The total carried interest on a top-performing $10MM venture fund is something like $2-5MM – and pays out after 5-10 years. The carried interest on a top-performing $1B hedge fund is $200-500MM. That’s a 100x difference. Clearly, not all carried interest is the same. 

Assuming a 2x return on a $10MM fund versus a $1 Billion fund, a 20% carried interest is $2MM versus $200MM respectively. The 17% tax differential between ordinary income and capital gains is $340K versus $34MM respectively.

Assuming a 2x return, my carried interest on my first $10M venture capital fund could put one of my two daughters through college. Steve Schwartzman’s carried interest on his first $1B buyout fund could buy a G6 jet.

New venture capital funds are small businesses – and they should be treated by the SBA and IRS as such.

At most, Congress could institute a lifetime max on Section 1202 benefits – but venture capital is already the red-headed stepchild of alternative investments, and if any generous, diversity-loving individual or family office LP wants to go through the trouble of figuring out how to underwrite first-time fund managers, especially diverse ones, they deserve the industry’s and the IRS’s full support.

If the U.S. is to increase diversity in venture capital, it won’t get there by promoting people in existing funds up the narrow ladder established by white men. No, more diversity in venture capital is promoted by helping first-time women and BIPOC fund managers raise their first few funds, gain a greater share of the 99% of capital currently controlled by white men—and Section 1202 QSBS and the capital gains tax treatment of carried interest helps the cause, like it or not.

So, Congress: Go ahead and make the change. But please, use extreme caution when making changes to the tax treatment of carried interest to avoid hurting the progress being made by female and BIPOC fund managers, giving special consideration to the first $10 million – just as Section 1202 does – in order to continue to promote much-needed diversity in venture capital.