Why Do Venture Capital Funds Burn Research and Development Deductions?

Abstract:     
Venture capital (VC) funds form a separate C corporation for each venture that they support within their portfolio of diverse ventures. The separate incorporation of each portfolio venture loses tax value that could be achieved from deducting research and development (R&D) costs. The tax deductions of the ventures are trapped within a corporation that cannot use them. The resulting taxes are draconian, sometimes confiscatory. If R&D deductions were used optimally, taxable investors could achieve a tax regime that would not reduce their pre-tax return.

The justifications offered for separate incorporation of each portfolio venture do not survive scrutiny. Separate incorporation is said to be required to protect tax-exempt investors, but if R&D deductions were passed out to taxable investors, taxable investors would drive taxexempt investors out of the funds. If capital must come from tax-exempt investors, the funds should still be trying to use the R&D deductions against taxable income of the successful ventures. Tax-exempt investors, in any event, do not justify the draconian taxes the VC funds bring upon themselves through their structure.

Number of Pages in PDF File: 64

Keywords: tax, venture capital, R&D

JEL Classification: O32, E22, G24

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