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.
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).
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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'Carried interest' is back on the table and so are the private equity industry's defenders.
FORTUNE -- President Obama today unveiled his federal budget proposal, which included a change to how private equity fund managers are taxed on investment profits (i.e., carried interest). Basically, it would tax carried interest as ordinary income, rather than at the lower capital gains rate. And, to be clear, this only relates to gains where the MOREDan Primack - Apr 10, 2013 4:58 PM ET
The carried interest tax debate isn't about deficit reduction.
FORTUNE -- Steve Judge, president of the Private Equity Growth Capital Council, today wrote an op-ed arguing that carried interest should continue to be treated by the IRS as a capital gain. Nothing particularly new in his fundamental argument, so it's not worth relitigating my disagreement.
But Judge did add one wrinkle that should be noted (and then disabused). From his piece:
"Changing the tax MOREDan Primack - Mar 4, 2013 4:25 PM ET
Democrats still have some revenue-raising options after their fiscal cliff win.
FORTUNE -- Democrats apparently are worried that they won't have any leverage in upcoming debt ceiling and sequestration debates, after succeeding last night in raising taxes on America's top earners. It's a bit like a Super Bowl-winning team fretting over its free agents before even having the parade. So here's a bright spot for those on the left who refuse MOREDan Primack - Jan 2, 2013 2:49 PM ET
Has the carried interest tax debate expanded?
While in Chapel Hill this past weekend, I caught a "state of the VC market" talk by National Venture Capital Association president Mark Heesen. During a section on regulation, Heesen raised the issue of carried interest taxation – but then spent several minutes on the topic without again referencing the term "carried interest." Instead, he spoke about how a move is afoot on Capitol MOREDan Primack - Apr 17, 2012 1:45 PM ET
Mitt Romney keeps refusing to answer a simple question.
As a private equity investor, Mitt Romney earned millions in additional income through the tax treatment of carried interest as capital gains rather than as ordinary income. As a presidential candidate in 2007, Romney said that he believed that carried interest should continue to be treated as a capital gains. As a presidential candidate in 2012, however, Romney tap-dances around the issue MOREDan Primack - Mar 7, 2012 11:31 AM ET
Venture capitalist Marc Andreessen believes that carried interest should be treated as ordinary income, according to comments made this morning on CNBC's Squqak Box. He is the latest in a small, but growing number of influential VCs who agree with President Obama that they are paying too little tax on investment profits derived from third-party capital:
"My personal view is carried interest should be treated as ordinary income. It's a fee for service. MOREDan Primack - Mar 2, 2012 9:13 AM ET
Obama again goes after the loophole that will not close.
President Obama today released his $3.8 trillion budget proposal for fiscal year 2013, and once again he is proposing to change the tax treatment of carried interest from capital gains to ordinary income.
Here is the section (pg. 40):
Tax Carried (Profits) Interests as Ordinary Income. Currently, many hedge fund managers, private equity partners, and other managers in partnerships are able to pay MOREDan Primack - Feb 13, 2012 11:47 AM ET
Investment managers have held on to it for years, but 'carried interest' carries an odious loophole that needs to go.
FORTUNE -- Politics has moments when it's actually useful. Case in point is the uproar over Mitt Romney's tax returns, which may help rid us of a small but noxious and symbolic loophole worth several billion dollars a year to managers of investment partnerships.
I'm talking about "carried interest" -- finance-speak for MOREAllan Sloan, senior editor-at-large - Feb 8, 2012 5:00 AM ET
Mitt Romney used to support the carried interest tax loophole. Now we have no idea.
Mitt Romney today released his 2010 and 2011 tax returns, which showed that he earned $12.9 million from carried interest, or the percentage of investment profits earned by private equity fund managers. And he also took advantage of a tax loophole that treats carried interest at the capital gains rate of 15%, even though someone else MOREDan Primack - Jan 24, 2012 11:01 AM ET
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