Twitter's other tax loophole

November 7, 2013: 5:06 PM ET

Congress wants to squeeze more tax revenue out of Twitter, but it's looking in the wrong place.

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FORTUNE -- As Wall Street toasted Twitter this week, a very different view toward the company took hold in Washington, D.C., where Senators John McCain (R-AZ) and Carl Levin (D-MI) accused Twitter of exploiting a massive tax loophole. Specifically, they wrote:

"When Twitter goes public later this week, the company may avail itself of this existing tax loophole. Under this loophole, the company will be able to take an estimated $154 million tax deduction for a stock option compensation expense which its own books show cost Twitter only $7 million... Given the deficit and damaging sequester cuts facing this country, this corporate stock option tax deduction is the kind of tax loophole that ought to be closed."

I don't happen to agree with my friends from Arizona and Michigan, largely because the federal government will still recoup those tax dollars from company employees. But that isn't the argument I'm looking to make in this post. Instead, let me un-bury the lead:

If Congress really wants the federal government to cash in on the Twitter (TWTR) IPO, there's a much less controversial tax loophole to close: Carried interest.

MORE: Twitter leaves more than $1 billion on the table

For those who slept through the 2012 election, carried interest is the percentage of profits that venture capitalists earn on their investments. It's usually around 20%, and gets taxed as a capital gain rather than as ordinary income. That last part effectively allows a VC to pay 14% less in taxes than he would were carried interest treated as ordinary income (if you include the Medicare surcharge).

You may think that sounds fair, since capital gains are designed to reward investors for taking risk (and we need investors to help build businesses). The only problem is that VCs actually are investing other people's money -- college endowments, teacher pensions, etc. -- and the only real risk they take is doing a lousy job and not being asked to manage other people's money in the future. In other words, carried interest should be ordinary income. Don't believe me? Perhaps then you'll believe Fred Wilson, who led Twitter's first round of VC funding back in 2007.

As you might imagine, Wilson and his fellow Twitter backers are poised for quite the windfall. And the tax benefits from carried interest actually outstrip what McCain and Levin are worried about when it comes to stock options.

It's impossible for me to do precise calculations due to what information Twitter has not disclosed, so what follows errs on the side of conservatism. It also only includes three of Twitter's many venture capital backers -- Benchmark Capital, Spark Capital and Union Square Ventures -- because it is easiest to estimate their original cost bases. I'm also assuming a 30% carried interest for Benchmark (based on past reporting) and a 20% carried interest for Spark and Union Square (although both may be higher).

MORE: NYSE rubs salt in NASDAQ's Twitter wound

Twitter raised $55 million in its first three rounds of funding, most of which came from the aforementioned firms. Benchmark and Spark also participated in a $100 million Series D round. I'm going to ballpark their combined investment at $70 million.

Based on today's closing price of $44.90, their combined position now would be valued at $4.12 billion. The actual profit would be around $4.05 billion. Let's average out the carried interest to 23.33%, which comes to around $945 million. Assuming a 14% differential between capital gains and ordinary income, the VCs save just over $132 million. Or, put another way, the sequestration-starved federal government loses just over $132 million.

That's a bit less than the $147 million in Twitter tax deductions that McCain and Levin believe are undeserved, and doesn't really begin to scratch the surface of the discrepancy.

For example, I didn't include profits from shares that both Spark and USV sold previously during secondary sales. Nor the massive value of shares held by Rizvi Traverse, Twitter's largest single outside shareholder -- and one that also benefits from carried interest tax treatment. Nor many of the VC firms with <5% stakes, including Institutional Venture Partners, Insight Venture Partners and Kleiner Perkins Caufield & Byers.

If we added all of that up, it would easily leave $147 million in the dust.

To be sure, I have no problem with legislators using a new hook to promote their tax policy proposals. I just wish they'd focus on the ones that really matter.

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About This Author
Dan Primack
Dan Primack
Senior Editor, Fortune

Dan Primack joined Fortune.com in September 2010 to cover deals and dealmakers, from Wall Street to Sand Hill Road. Previously, Dan was an editor-at-large with Thomson Reuters, where he launched both peHUB.com and the peHUB Wire email service. In a past journalistic life, Dan ran a community paper in Roxbury, Massachusetts. He currently lives just outside of Boston.

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