Here a loophole, there a loophole

Most of the richest Americans that populate the annual Forbes 400 list gained their wealth by owning founders' stock. Allowing favorable tax treatment on this stock might be costing taxpayers by $100 billion a year, or $1 trillion over ten years.

Victor Fleischer sees things a little differently than most. He has a talent for spotting what he feels are inequities in the tax code.  Back in 2007, Fleischer, a corporate attorney and tax professor at University of Colorado Law School, wrote a paper questioning the tax treatment of what is now commonly called carried interest.* His argument won the attention of Congressional staffers and the result was HR4213 (which has passed in the House three times but has not yet become law).  Those who would be directly affected if HR4213 passed - partners at private equity firms - argued to him that they should not be targeted because people like Bill Gates are not targeted. Fleischer thought through their idea and decided they were right. But instead of letting them off the hook, he wrote another paper that could close the loophole that benefits Gates and other company founders.

According to Fleischer, most of the richest Americans that populate the annual Forbes 400 list gained their wealth by owning founders' stock. When startups arise, the founder will often take common stock in the company in place of most of a salary. That way, he or she can defer paying tax until the shares are sold, at which time the founder pays, not ordinary income tax of 35 percent, but the much more favorable capital gains tax of 15 percent.  Fleischer told reporters at the New York Post that allowing this treatment saves those taxpayers about $100 billion a year, or $1 trillion over ten years.

This tax treatment has been widely defended as a way to encourage much needed innovation and entrepreneurship. But Fleischer doesn't believe that paying higher taxes would deter those inclined to create new businesses. "There are more effective methods of subsidizing entrepreneurship than by providing an unjustified tax break to the wealthy," he told the Post.

Fleischer told AccountingWEB, "There are better ways to subsidize entrepreneurship than through a tax subsidy.  When I talk to founders about why they do or don't start a company, tax is never the reason.  It's primarily geographic and cultural factors:  Can I find enough talented engineers in my town to make this work?  Are there mentors around who can tell me how to raise money, build a team, and execute the idea? 

"Even within the legal system, tax is less important than bankruptcy, securities, employment law, even immigration policy. 

"If Congress wants to subsidize entrepreneurship, I'd rather see it funding basic scientific research, improving our education system, and upgrading our technological infrastructure. That's what can keep us globally competitive for years to come."

Attorney David Miller of the New York-based international law firm Cadwalader, Wickersham & Taft told reporters that, after sitting in on a forum that looked at Fleischer's paper, he expects it to gain a lot of traction. "I have no doubt this will be just as explosive as the carried interest paper."

However, Miller has a different solution for the presumed tax inequity. He points out that innovators like Larry Page, co-founder of Google, take only $1 in salary and then borrow against their stock, effectively eliminating their personal income tax liability. Miller would like to see them pay taxes on the stock appreciation.

Time will tell whether or not the tax treatment of founder's stock is about to come under fire. But with Congress thrashing about looking for new sources of taxes in every nook and cranny, entrepreneurs may need to spend some face time with their tax advisors to map out new compensation plans.

* Carried interest is defined as a share of profits paid to the general partners of private equity and hedge funds - in spite of not having contributed funds - as compensation for the hard work general partner (or fund manager) to improve the fund's performance.

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