Fernway DiarySM

Jan 10, 2022

The Biden administration has been frank in their intention to modify the US tax code to raise taxes for the country’s highest earners. Subjects under discussion have included increases to the long-term capital gains rate and top federal income tax rate. While legislation is still under discussion in Congress, startup founders, investors, and employees should be aware of the current proposal to modify tax laws relating to Qualified Small Business Stock (QSBS).

The Qualified Small Business Stock Exclusion

Internal Revenue Code Section 1202 allows taxpayers who sell QSBS under strictly defined conditions to exclude up to $10 million of federal capital gain, or 10 times their basis in the stock, annually from federal capital gains taxes, provided they have held the shares for at least 5 years. Originally enacted in 1993, the QSBS exemption was intended as a tax incentive for small business owners, their investors, and early employees. Both the shareholder and the company have to meet a number of restrictive requirements in order for this exclusion to apply, of which the broadest outlines are:

To be considered a “qualified trade or business” under the provision, the stock-issuing company should (amongst several other requirements):

• Be a C Corporation in the US.
• At least 80{d61ad4666dda706b731686a225909392f074403d16c1288901cab8f2cf34ab1f} of the assets of such corporation should be used in the active conduct of a qualified trade or business.
• Have no more than 10{d61ad4666dda706b731686a225909392f074403d16c1288901cab8f2cf34ab1f} of its value composed of real estate or stock and securities.
• Cannot be engaged in certain specific types of business enumerated in Section 1202(e)(3).
• At all times during the Issuing Corporation’s existence up to the time immediately following the issuance of stock, the aggregate gross assets of the issuing corporation should be $50 million or less.
• Avoid shareholder redemptions above certain de-minimis thresholds since inception of the business.

To qualify for the exclusion, the shareholder should (amongst several other requirements):

• Receive shares from the company either in exchange for money or other property or as compensation for services.
• Hold the shares for more than 5 years.

(Various additional restrictions apply; shareholders or businesses interested in learning more or who are uncertain as to the applicability of these provisions holding should consult a tax professional.)

The current proposal before Congress would reduce QSBS federal exclusion rates to 50{d61ad4666dda706b731686a225909392f074403d16c1288901cab8f2cf34ab1f} for individuals reporting more than $400,000 adjusted gross income in a single year. As written, it would likely also be retroactive to sales or exchanges occurring after September 13, 2021. While the stated intent of lawmakers is to target the wealthy, the tech startup community in particular is concerned that the change, if enacted, could have a negative impact on early-stage startups.

How QSBS Exemption Benefits Support Innovation

Stock and stock options have long been a way for cash-strapped early-stage startups to attract investors and reward employees. The tax benefits offered by the QSBS exemption have offered a significant incentive for those willing to undertake the financial risk of putting their resources and/or time into a company in its earliest stages of development. In the tech sector, many startups begin as QSBS-qualifying companies, leveraging the promise of tax-free gains for founders, investors, and employees to gain support.

Industry professionals fear that a significant reduction in QSBS exemption benefits could pose unforeseen implications for tech startup founders/employees as well as a chilling effect on investment in the field. In the case of an employee who exercises stock options in a company that goes on to become highly valued, a sale of stock could push them well above the $400,000 AGI limit on a one-time basis, exposing them to a high tax burden far out of proportion to their normal income. For investors, the higher-than-average risk of early investment in startup ventures has been balanced by a greater-than-average tax benefit should the company succeed. It would remain to be seen if funding would decrease in a less favorable tax environment.

As with other tax proposals under consideration by lawmakers, the QSBS exemption has not yet been altered, and the exact details of any final change are as yet unknown. Those concerned on the effect this proposed change may have on their current or contemplated startup ventures, or on their personal tax situation, are advised to seek professional advice to determine their best course of action in financial and tax planning.

For more information, please contact your US tax advisory team at youradvisor@fernwaysolutions.com or visit us at www.fernwaysolutions.com.

Disclaimer:

The above content is intended to support the marketing of professional services and should not be construed as written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular tax situation. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with, or attached to this content is not intended to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Fernway Solutions assumes no obligation to inform the reader of any such changes.