When we speak of disruption in the startup industry, it would not be uncommon to invoke an innovative technology or a visionary founder. It is a rare occasion when we can celebrate legislators. Yet, some of the most recent strides in the emerging growth ecosystem are owed not to Silicon Valley programmers in their Spartan incubators, but instead to the U.S. Congress.
In my conversations with venture capitalists, bankers, founders and lawyers, I am frequently startled by the lack of awareness for a neglected bit of tax innovation ordinarily called QSBS, or qualified small business stock.
Accounting for only a few pages of legislation, this tiny tax provision has multi-million-dollar consequences and represents an aggressive policy favoring investors and entrepreneurs. QSBS allows these shareholders to avoid paying taxes when cashing out on their startup. For those savvy enough to take advantage of these rules, the enormous savings create powerful incentives for early-stage growth, the lifeblood of the Bay Area tech scene.
Consequently, it should be no small matter that the Trump administration may be rolling back the tide on one of the most important and one of the least understood measures impacting U.S. technology markets.
To help you better understand this provision, imagine you are an early employee of a startup and you received shares as part of your compensation package. Or perhaps you are a venture capitalist who received a preferred interest in exchange for investing in a seed or Series A round. Let’s suppose that after five years, the company goes public, the business is purchased or you decide to sell your interest on the secondary market. Chapter 26, Section 1202 of the tax code says that a gain from any sale of “qualified small business stock” will be partially excluded from capital gains treatment if the stock is eligible under its various subparts.
In general, if a company has raised less than $50 million, is a startup in the way we typically understand them and is still an active business, the stock would qualify when held for more than 5 years, and the proceeds from that sale would be partially excluded from capital gains! That was true until September 2010, when the exclusion increased yet again (with no AMT add back).
Initially intended to be temporary, in December of 2015, Congress signed the PATH Act (Protecting Americans from Tax Hikes), which revisited this decades-old tax policy. The rules, now permanent, provide 100 percent exclusion from capital gains for the proceeds from the sale of qualifying stock for any amount equal to the greater of $10 million dollars or 10 times the basis/your investment — not bad for government work.
The startup ecosystem would be wise to evaluate how these tax policies, and these investment incentives, will be affected.
The policy underlying this tax provision suggests investors have a greater pecuniary incentive to make risky investments in early-stage businesses if the proceeds from those investments have favorable tax treatment. Small businesses fuel the American economy and create jobs. However, this policy presupposes that VCs are aware of these tax rules in the first instance, and are incentivized by them.
As I mentioned above, in my conversations with industry players, this is a widely ignored area of the code. Yet, for those who have benefited from these rules, it can be very lucrative. With the Trump administration now defining itself, and with Republicans occupying majorities in both houses of Congress, the startup ecosystem would be wise to evaluate how these tax policies, and these investment incentives, will be affected.
In addition to calling for the end of carried interest (a shibboleth of presidential campaigners), section 3136 of Camp’s bill, titled “Termination of Special Rules for Gain from certain Small Business,” unambiguously amends portions of section 1202 to exclude any use of QSBS for stock purchased after the bill’s enactment, and strikes section 1045, which provides a safe harbor for rolling over QSBS investment proceeds. In other words, the then-leading Republican on the House Ways and Means Committee has called for the death of QSBS.
In Washington, any proposal by the Ways and Means Committee chairman would usually serve as a strong benchmark for legislation that would likely become law. However, in these circumstances, Camp released this bill on his way out the door. While this bill was introduced without sponsors, and expired soon thereafter, the consequence of its creation, and who created it, should leave stakeholders on Sand Hill Road uncertain about the future of QSBS.
Former House Speaker John Boehner called the plan “the beginning of [a] conversation” on tax reform. Paul Ryan, who replaced Camp as chairman for a brief tenure before being promoted to Speaker of the House, said “[Camp] basically got the country and Congress thinking about it to the point where we’re now discussing not if, but when.”
Before vacating the committee, Ryan directed House leadership, in cooperation with the House Ways and Means Committee, to create six task forces and launch a series of public hearings to address the “broken tax system” and develop policy recommendations for the new administration.
A Better Way, Our Vision for a Confident America was released in June of 2016 as a blueprint for GOP tax reform. An unnamed lobbyist with close ties to the VC industry suggests that because many of the policies in Camp’s bill have been absorbed by the GOP’s blueprint, there is a much stronger likelihood that a Trump White House could mean the end of QSBS. The blueprint, now the go-to reference material for a Trump tax plan, makes no mention of QSBS. Instead, we are left to decipher sweeping statements like, “[t]his Blueprint generally will eliminate special-interest deductions and credits in favor of providing lower tax rates for all businesses and eliminating taxes on business investment.” Or, “[f]or businesses both small and large, the focus of the new tax system will be on the growth and competitiveness of all job creators.”
While it remains unclear the extent to which President Trump would adopt the perspective of David Camp, the former chairman for the House Ways and Means Committee, Camp’s proposal has nevertheless influenced the GOP blueprint, and has initiated a dialogue that threatens to eliminate QSBS and significant savings available to the venture capital ecosystem.
The question remains in the months ahead: What degree of influence will Camp’s comprehensive legislation have on a new and unpredictable administration? For all those who continue to elect QSBS, this would, as we have seen, most certainly be painful. Though, one might pause to ask whether QSBS is worth saving if so many stakeholders aren’t aware of its existence. Despite so many founders, investment professionals and service providers being unaware and unmotivated by these tax benefits, at the very least the existence of these proposals represents a serious assault on the valley.