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The
US Tax Regime for Venture Capital
Unlike
many other countries that seek to foster venture
capital investment, the US provides no federal
tax breaks as such - that's to say, no deductions
are allowed of initial capital expenditure against
current income. However there are such deductions
at the state level in many cases - whether this
matters depends on income tax levels in a particular
state. They vary from 1% to 12%.
Still,
the overall tax regime for venture capital investment
in the US is reasonably benign, which is why the
absence of specific federal tax breaks has not
impeded the growth of a successful venture capital
sector.
Important
features of the US federal tax system for investment
are that interest expense involved in investment
is deductible against investment returns and to
some extent against regular income, capital losses
are offsetable against gains, and losses on passive
investments (less than 10% of a company, and including
investments held through a limited partnership)
are deductible against investment income (income
within the passive 'basket').
Capital
gains are included within income in the US and
are subject to income tax; however, the maximum
rate of tax on gains, at the time of writing,
from investments held for more than 12 months
is between 0% and 15%, depending on the individuals'
marginal income tax rate. If a qualifying small-business
asset is held for more than five years, there
is a 75 % exclusion of capital gains on disposal
for stock acquired after February, 17 2009 and
before January 1, 2011. The exclusion will be
50% for stock acquired after December, 31 2010.
The
corporate forms used for venture capital investment
are almost always 'pass-through', ie the limited
partnership or similar is fiscally transparent,
so that its gains or losses are attributed to
investors without intervening taxation. Evidently,
this does not apply to publicly-listed venture
capital funds which take the form of mutual funds
(often, funds of funds), and are taxable in their
own right.
As examples of state-level schemes favouring venture
capital investment we will take Virginia, which
passed a fairly typical law resembling that in
other states where there is a substantial high-tech
community.
In
Virginia, the 1998 so-called 'angel investor'
law gave people who invest in small high-tech,
biotech and manufacturing firms a state income
tax credit for 50% of their investments. The investment
must be for cash and neither the investor, the
investor's family nor the investor's affiliates
can receive any type of compensation from the
business for one year. The maximum credit is USD50,000
at the time of introduction, and, although the
investment must be held for five years, the investor
can apply for a tax credit immediately. The credit
is available for individuals and estates only
- businesses cannot receive the credit.
Eligible
businesses receiving the investments must have
annual gross revenues under USD5 million, must
operate principally in Virginia and cannot be
in the fields of or related to banking, finance,
construction and consulting.
Some
states allow the deduction against business income
tax as well as giving it to individuals.
The
'Carried Interest' Debate
Over
the past few years there has been constant pressure
from Democrats in and out of Congress to change
the basis of taxation of fund managers (including
venture capitalists). Currently, the standard
basic fee structure for managers of hedge and
private equity funds is 20% of gains made by the
fund, plus a 2% management fee. The profit element
is known as 'carried interest' and is normally
taxed as a long-term capital gain at 15%, rather
than as income at 35%.
In
April, 2009, Democratic lawmaker Sander Levin
reintroduced legislation into the US House of
Representatives that would tax fund managers'
carried interest compensation at the same rates
as ordinary income.
As
of late 2010, proposals to increase tax rates
on carried interest are mired in Congress along
with the 'tax extenders' legislation, and it is
not possible to predict the outcome.
This
issue is explored at greater length in the Policy
Issues section of this site.
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