Big Changes to Small Business Stock: How Venture Capital Investors Must Adapt to Evolving Tax Law
October 14, 2021
By Matthew Talia
The old adage ‘If it seems too good to be true, it probably is’ may describe how venture capital investors felt after the House Ways and Means Committee’s proposal to reduce the tax benefits provided by qualified small business stock (QSBS). While at first glance this would seem harmful to venture investors, QSBS still provides a tremendous benefit in a period where tax rates are assuredly on the rise. It was initially thought when the Treasury Department released its fiscal year 2022 revenue proposals, colloquially known as the “Green Book,” that QSBS, governed under IRC Sec. 1202 would remain untouched. However, to generate more revenue under the tax bill currently being negotiated by Congress, the proposal would reduce those currently eligible for 75% or 100% QSBS capital gain exclusion to 50% effective on or after September 13, 2021. This would only apply to taxpayers with an adjusted gross income (AGI) equal to or exceeding $400,000. Trusts and estates would only be eligible for 50% capital gain exclusion regardless of their taxable income. The 50% capital gain portion not excluded will be subject to 28% capital gains tax rate and net investment income tax. The 50% excluded portion will be subject to the AMT.
However, it should be noted that the tax changes are not yet set in stone as the bill is currently working its way through the House of Representatives, where it has struggled to gain consensus. The final bill ultimately presented to the Senate and then to the President may be materially different. The tax code remains favorable and still accomplishes its goal of incentivizing early-stage investment. Both early-stage investors and fund managers, now more than ever, should pay special attention to tax planning in order to ensure the highest possible post-tax return on investment.
IRC Sec. 1202 was enacted to encourage investment in small business by providing tax benefits to those willing to take on the risk and uncertainty associated with early-stage companies. It outlines what requirements must be met in order to be considered a qualified small business (QSB). With certain exceptions, a QSB is a C corporation engaged in an active business with the tax basis of gross assets under $50 million. For an investor to qualify for QSBS treatment they must acquire stock of the corporation at its original issuance and hold it for at least five years. QSBS can be held by non-corporate taxpayers such as partnerships, LLCs, trusts, individuals, and S corporations. Below is a table summarizing the current exclusion benefits based on date of acquisition, tax rates on QSBS gains that are not excluded, and AMT implications.
The exclusion limitation for QSBS during a taxable year is the greater of $10 million less excluded capital gains in prior tax years, or ten times the taxpayer’s adjusted basis in the QSBS. It should be noted that this exclusion does not apply to the sum of all the taxpayer’s QSBS gains, but to each QSBS since it is determined on a per issuer, per taxpayer basis. IRC Sec. 1045 is a companion to IRC Sec. 1202, and allows a taxpayer to rollover proceeds, holding period, and basis from the sale of QSBS held for more than six months but under five years into a new or multiple QSBS within sixty days of sale. This strategy is commonly employed by venture investors and funds since it avoids taxable capital gains while allowing investors to seamlessly reinvest their capital into new QSBS. For specific nuances and general information regarding QSBS, please refer to The Most Overlooked Tax Break for Long-Term Investors: IRC Section 1202 Exclusion of Gain from Qualified Small Business Stock.
An investor who purchases QSBS would be well-served to evaluate their personal tax situation, investment allocation, structuring, and due diligence processes. Venture capital remains an attractive opportunity, but if this change is enacted, investment expectations would need to be adjusted. It is a good time for investors to consider how much capital as a percentage of their portfolio they would like to have in the venture space. Venture capital investments are typically high-risk, high-reward propositions. The proposed tax change must be factored into the risk-adjusted return on capital equations utilized by investors and their advisors. In the simplest of scenarios, where a taxpayer in the highest tax bracket realizes a $10 million capital gain from sale of QSBS purchased after September 28, 2010, their tax liability balloons from zero to $1,590,000.1
Investment fund managers can use this proposed change as an opportunity to proactively speak with their tax advisor and investors about the tax implications of their strategy. Existing or new fund managers who can articulate their tax plan to investors will have an edge when it comes to investor relations and raising capital. It is essential that managers have a process in place to identify and document investments that are eligible for QSBS treatment under IRC Sec. 1202 and IRC Sec. 1045. There are many potential pitfalls throughout the investment, sale, and rollover process in which an investor can mistakenly lose QSBS status. Faulty documentation, failing to maintain the active business requirement, improperly executing an IRC Sec. 1045 rollover in a timely fashion, failing to account for convertible options, and not acquiring original issue stock are just a few common oversights that have costly ramifications for investors.
While it would be wishful thinking if QSBS treatment escaped Congress unscathed, it cannot be overemphasized how favorable the tax treatment of QSBS remains. Even after factoring in the reduction of the exclusion amount, early-stage investment is clearly encouraged regardless of what tax bracket one falls into. There are many opportunities for investors and investment managers alike to take advantage of this treatment and vigilantly monitor potential tax scenarios. Proper tax planning and execution of QSBS is essential to boosting post-tax returns that are simply unavailable to competing alternative asset classes.
1 Calculated using a $5 million exclusion, 28% tax rate, and 3.8% net investment income tax rate.