Earlier this year, Southern California became the second-biggest center of venture capital funding. But by early next year, this region could become the biggest potential loser of VC funding if a proposed tax change makes its way through Washington.

The issue revolves around so-called carried interest. Carried interest is the proverbial pot at the end of the investment rainbow for VC-funded companies; it’s the money that gets divvied up when a VC-funded firm goes public or gets acquired. Congress is eyeing the notion of taxing that money not at the current 15 percent capital-gains rate but at the ordinary-income rate, typically 35 percent.

Now, if that tax rate is doubled, it may not kill those in the VC community, but it’ll sure beat them up. They’ll fund fewer companies and be far choosier about the companies they do fund. And that will mean that lots of VC-needy firms may be starved of the money they need to get to the next level or take off.

“And it’ll hit most dramatically in the L.A. area,” said Mark Heesen, who is president of the VC industry’s trade organization, called, appropriately enough, the National Venture Capital Association, which is in suburban Washington.

How so? He explained that since Southern California and Los Angeles in particular are kind of new as a capital for VC funding, that means many established VC firms have not set up shop here (although, in fairness, Los Angeles does have some VC firms). Instead, many VC people tend to fly in from the Bay Area or from New England.

But if the tax rate is boosted, those VC guys are far more likely to stay home. It’s the old bankers’ rule: Conservative lenders don’t make out-of-territory loans.

“That hurts an area like L.A. far more than it hurts Silicon Valley or Boston,” said Heesen, who visited Los Angeles last week.

Although it has been reported that the carried-interest issue appears to be dead for this year, Heesen believes it has a good chance of popping up again soon. And if not this year, next.

The VC group’s strategy is to try to draw a greater distinction between venture capital and private equity. Since Congress got into the whole carried-interest issue as a way to cash in on the enormous profits of some private equity firms, the VC firms hope to convince lawmakers that they are different and they should get an exemption from any new carried-interest tax law change.

By the way, the Bay Area is still No. 1 for receiving VC money. However, Southern California bypassed New England earlier this year as the No. 2 recipient.

Why? Heesen believes it is because this region has the kinds of businesses most interesting to VC firms today, such as companies that create homeland-security oriented products as well as media and entertainment companies that are going onto the Internet.

Also, lots of funds, particularly public funds, want to invest in green and clean technologies, and California has been aggressive about making that an industry. Beyond that, UCLA, USC and Caltech are adept at tech transfer.

Add it all up, and this area is developing a more exciting entrepreneurial culture. It would be dispiriting, indeed, to see that set back by any tax decision in Washington.

Charles Crumpley is editor of the Business Journal. He can be reached at [email protected].