Corporate Organisation of VC Firms in the US
Most mainstream firms or wealthy individual investors invest their capital through funds organized as limited partnerships.

Exiting a Venture Capital Investment
Exit routes consist of an IPO (initial public offering), trade sale of shareholdings, merger or acquisition.

The US Tax Regime for Venture Capital
The overall tax regime for venture capital investment in the US is reasonably benign.

Policy Issues Affecting Venture Capital

There are a number of ongoing issues which are relevant for venture capitalists in the US.

Accounting Standards

The Financial Accounting Standards Board (FASB), an independent regulatory body overseen by the Securities and Exchange Commission (SEC), has wanted for some years to eliminate pooling accounting for business combinations. In Europe, the equivalent technique, known as merger accounting, has been banned, and the International Accounting Standards Committee (IASC), an advisory body made up of representatives from FASB and other foreign accounting standards boards, is against it.

Under pooling, the balance sheets of the two companies are combined, and no change in asset value is recognized. Under purchase accounting, a business combination is treated as the purchase of one company by another. The value of the purchased company is then treated as an asset and the value is restated to reflect the price paid to its shareholders. Purchase accounting poses serious difficulties for tech sector growth companies because of the costs involved. This is mainly because under established purchase accounting rules, goodwill (the difference between the purchase price and the value of all identifiable assets of the purchased company) must be allocated to intangible assets amortized over a period of time. These amortization expenses often can cause a company that would otherwise report profits to instead report losses.

By 2008, after a series of progressive steps, the FASB had substantially achieved its goal of banning merger accounting, with its Statement No. 141(R), Business Combinations, having been able to agree compromise standards on a range of issues including the amortisation of goodwill.

Stock Options

The IASC issued a paper in 2000 calling for rules to require companies to expense the stock options they offer to directors and employees. The FASB had made a similar proposal some years before but ultimately dropped it in the face of fierce industry and congressional opposition. Business has long maintained that stock options are not to be viewed as compensation and thus should not be expensed. This proved to be only a temporary setback for the IASC and FASB, and by 2006 the FASB had successfully installed a rule requiring the expensing of stock options.

Expensed or otherwise, stock options have been a fruitful source of controversy over the years, and the Treasury has made numerous moves to clamp down on what it sees as abusive aspects of option issuance:

• In February, 2004, the US Treasury Department and the IRS issued a revenue ruling that would shut down an aggressive transaction involving the exercise of stock options by corporate insiders using debt financing provided by the corporation. In these transactions, typically the corporate insider will exercise options he or she holds by giving the company a promissory note. If the value of the stock later falls below the face amount of the note, the company may agree to reduce the insider’s debt. Certain individuals have claimed that this debt reduction does not result in taxable income.
  
• In January, the Treasury issued a ruling to shut down abusive transactions involving ‘S corporation ESOPs’ (employee stock ownership plans) in a ruling that will classify such investments as listed transactions for the purposes of tax shelter disclosure. According to a Treasury statement: “The ruling shuts down transactions that move business profits of the S corporation away from the ESOP, so that rank-and-file employees do not benefit from the arrangement. For example, the ruling prohibits using stock options on a subsidiary to drain value out of the ESOP for the benefit of the S corporation’s former owners or key employees.” Treasury Assistant Secretary for Tax Policy Pam Olson observed: "Congress recognized the potential for attempts to circumvent the rules and specifically authorized Treasury and IRS to prevent it. This notice does just that, imposing a 50% excise tax on the option holders in cases where rank-and-file ESOP participants are deprived of the business profits."
  
• In July, 2003 the Treasury announced the closure of a tax loophole promoted to executives enabling them to defer income tax on stock option gains beyond the exercise of the option. The method employed to execute this scheme involves the transfer of stock options to a family member or family-owned limited partnership in which the executive has a significant interest. The executive then receives a long term unsecured note in exchange whilst the relative exercises the option, stating that they will not recognize any gains until it is subsequently sold and then only if the proceeds are more than the price paid for the option and the exercise price. The scheme's promoters claim that no tax needs to be paid on the option until payments are made on the long term note. The Treasury Department says: "The IRS will challenge the executive’s claim that income from the exercise of the stock options can be deferred. The regulations, which are effective immediately, prevent an executive or any other person from claiming tax deferral from the transfer of options to a related party."
  
• In October, 2004, tax experts voiced fears that when the Treasury Department comes to draft regulations for the expensing of stock options, the benefits of stock appreciation rights (SARs), a form of stock-based pay that has been steadily growing in popularity, may be nullified. SARS give employees the right to any increase in a stock’s value between the granting of the rights and the time it is exercised, and a change in accounting rules that will require firms to recognize the cost of stock options as an expense on their income statements was expected to boost the popularity of this form of compensation further. However, tax and pay experts fear that provisions in the draft regulations will take the shine off SARs by requiring beneficiaries to disclose ahead of time when they intend to exercise their grants. If a date is not set, then executives could be compelled to pay tax when the award vests, as opposed to paying tax when the income is realized. Employees typically have ten years from the date of the grant to cash in SARs. Unless SARs are exempted from the deferred compensation rules, it is feared by many observers that the schemes will be unable to function, and most companies will withdraw them in favour of other forms of incentive.
  
• In December of that year, the Treasury announced new guidance concerning changes to certain executive compensation rules brought about by recently passed tax legislation. The legislation surrounding deferred compensation plans was tightened as one of the revenue-saving measures contained in the corporate tax bill passed by Congress in October. By placing access restrictions on monies contained in deferred compensation plans, lawmakers are hoping to prevent a repeat of some of the abuses witnessed in the Enron affair, when several executives siphoned off assets from deferred accounts shortly before the firm went bust. The new rules will make it more difficult for a beneficiary to take out money from such a plan without incurring a 20% penalty. To avoid this penalty, it is likely that the rules will stipulate that deferred payments must be made only at specified times, such as the end of employment or death, whilst executives classed as ‘key employees’ may not be able to receive deferred compensation for six months after ending their job with a company. The new rules are expected to prompt a wholesale review of executive compensation schemes to determine what forms of pay will be caught by the revised legislation.
  
• In June 2007, US hotel chain Marriott International, Inc. announced that it had paid $220 million to the Treasury and a number of unnamed states to settle a tax dispute relating to its leveraged employee stock ownership plan (ESOP). The payment stems from an Internal Revenue Service audit of Marriott's 2000-2002 tax returns, which uncovered $1 billion in deductions that the company took from the employee stock ownership portion of a program called 'Employees' Profit Sharing, Retirement and Savings Plan and Trust'. As a result of the settlement, the company revealed that it would make cash payments to the Treasury and state tax jurisdictions of approximately $220 million. The payments reflect income taxes, excise taxes and interest charges. No penalties were assessed.
  
• In April 2008 The US Securities and Exchange Commission (SEC) charged Broadcom Corporation with falsifying its reported income by backdating stock option grants over a five-year period. As a result of the fraud, Broadcom restated its financial results in January 2007 and reported more than USD2bn in additional compensation expenses. The Irvine, Calif.-based semiconductor maker agreed to settle the charges, and consented to pay a USD12m penalty. "The backdating scheme at Broadcom went on for five years, involved dozens of option grants, and resulted in the largest accounting restatement to date arising from stock option backdating," explained Linda Chatman Thomsen, Director of the SEC's Division of Enforcement, continuing: "The scope and magnitude of the fraud warrants the significant penalty imposed on the company." Rosalind R. Tyson, Acting Regional Director of the SEC's Los Angeles Regional Office, added that: "Today's action highlights the ways in which certain companies have abused option grants. Broadcom used lucrative in-the-money grants to recruit and retain talented employees without paying them higher cash salaries, but avoided the requirement to report the billions of dollars in compensation expenses by secretly backdating the options." In a complaint filed in the US District Court for the Central District of California, the SEC alleges that from June 1998 to May 2003, Broadcom, acting through its top officers, misrepresented the dates on which stock options were granted to executives and employees. The SEC further alleged that, as a result of the backdating scheme, Broadcom avoided reporting USD2.22bn in compensation expenses during the relevant period. Without admitting or denying the SEC's allegations, Broadcom agreed to settle the charges by consenting to a permanent injunction against further violations of the antifraud, record-keeping, financial reporting, internal controls, and proxy provisions of the federal securities laws, and payment of the USD12m penalty.
  
• Combating accounting fraud, including illegal stock option backdating, was a priority for the SEC in fiscal year 2008. During the year, the SEC charged eight public companies and 27 executives with providing false information to investors based on improper accounting for backdated stock option grants.
  
• In August 2008, a report claimed that US taxpayers are effectively subsidizing excessive executive compensation to the tune of billions of dollars every year as a result of loopholes in the tax code. The 15th annual 'Executive Excess' report from the Institute for Policy Studies and United for a Fair Economy calculates that the annual cost to taxpayers of five commonly-used tax and accounting loopholes that encourage excessive executive pay is USD20 billion annually. The most expensive of these loophole as far as the US Treasury and the average taxpayer are concerned is the stock option accounting double standard. Under Section 83 of the tax code, first enacted in 1969, the stock option tax deduction does not reflect the expense shown on a company’s books. Instead, the stock option deduction is calculated on the date that a stock option is exercised, which is often years after it is granted. The deduction is equal to the difference between what the employee paid to exercise the option and the market value of the shares on the exercise date.
  
• In October 2008 the Treasury Department announced that firms participating in its rescue programs under the Emergency Economic Stabilization Act would have to follow tougher tax rules governing executive compensation and adhere to stricter corporate governance standards surrounding executive pay in general. Under the Stabilization Act, any financial institution that sells more than USD300 million of troubled assets to the Treasury via an auction would be prohibited from entering into new executive employment contracts that include golden parachutes for the term of the program. In addition to this, financial institutions are prohibited from deducting executive compensation in excess of USD500,000 for each senior executive and certain golden parachute payments for tax purposes. Also, a 20% excise tax will be imposed on the senior executive for these golden parachute payments. The Treasury released IRS Notice 2008-94 regarding these new tax rules. These rules also apply to financial institutions participating in the Capital Purchase Program, which requires these firms to ensure that incentive compensation for senior executives does not encourage "unnecessary and excessive risks" that threaten the value of the financial institution.
  
• In March 2009 the US House of Representatives gave bipartisan support legislation written by Ways and Means Committee Chairman Charles Rangel to tax the bonuses of highly paid individuals employed at companies in receipt of bail-out funds at a rate of 90%. Meanwhile, over in the Senate, four members introduced legislation to discourage excessive compensation by companies that have taken taxpayer dollars by proposing a 35% excise tax on both employers and employees, on retention bonuses and other bonuses, and by imposing a limit on non-qualified deferred compensation. Small banks as defined by the tax code and entities that received less than USD100m in TARP funds would be exempt from this legislation. Senate Finance Committee Chairman Max Baucus said: “We must act quickly on this proposal – for the sake of the American taxpayer, for the sake of what’s right to do. I will work with my colleagues in both the House and Senate to make sure that’s what happens," Baucus added. The Senate bill directs the Treasury to issue guidance allowing an institution to cancel or modify an outstanding deferral election or an individual to terminate participation in the non-qualified deferred compensation plan without being subject to the legislation or the penalties that would otherwise apply under the tax code.

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.

“This is a basic issue of fairness,” said Levin. “Fund managers are receiving compensation for managing their investors’ money. They should not pay the 15% capital gains rate on their compensation when millions of other hard-working Americans, many of whose income is performance-based, pay ordinary rates of up to 35%."

The move is of course supported by President Obama who had inserted a similar proposal into his 2010 budget. "The budget proposes to tax the compensation paid to hedge fund managers, private equity partners and others in the same way that we tax the wages paid to ordinary American workers," Treasury Secretary Tim Geithner told the House Ways and Means Committee in March. "By closing this carried interest provision, the tax code will provide equal tax treatment for wages regardless of whether an individual works as a teacher or a hedge fund manager."

As long ago as June 2007, former United States Treasury Secretary Robert E Rubin had suggested that fund managers receiving pay through performance fees were not paying their fair share of tax, adding fuel to the debate as to whether curbs should be placed on the escalating sums earned by the top fund managers.

“It seems to me what is happening is people are performing a service, managing peoples’ money in a private equity form, and fees for that service would ordinarily be thought of as ordinary income,” Rubin said. He went on to state that the issue should be examined “with great seriousness” by the Congressional tax committees.

Senate Finance Committee Chairman Max Baucus (D - Mon) had also expressed concern that hedge fund and private equity fund managers are manipulating the US tax code to reduce their tax bills.

"The different rate between capital gains and ordinary income puts a lot of strain on the code," Baucus explained.

Adding to the debate, the industry's main lobby group suggested that new legislative proposals that would tax as corporations all publicly traded partnerships that directly or indirectly derive income from investment adviser or asset management services would leave the majority of US venture capital firms unaffected.

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Corporate Organisation of VC Firms in the US
Most mainstream firms or wealthy individual investors invest their capital through funds organized as limited partnerships.

Exiting a Venture Capital Investment
Exit routes consist of an IPO (initial public offering), trade sale of shareholdings, merger or acquisition.

The US Tax Regime for Venture Capital
The overall tax regime for venture capital investment in the US is reasonably benign.