The Biden administration recently clarified its proposed tax increases under the American Jobs Plan and the American Families Plan.
The Treasury Department’s General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals (Green Book) makes clear that the administration hopes to almost double the long-term capital gains rate from 23.8% to 43.4% for high earners. For startup founders and investors in California, the Biden-proposed changes will lead to draconian results. On the sale of their shares, founders and investors based in California could pay an effective tax rate of 56.7% (43.4% federal long-term capital gains rate plus 13.3% California rates). For these shareholders, the exclusion from gain on sale of qualified small business stock (QSBS) is now critical.
Qualified Small Business Stock Generally
Tax code Section 1202 provides the statutory basis for the QSBS exclusion. In general, Section 1202 allows taxpayers who invest in certain types of startup businesses to exclude up to $10 million of gain or 10 times their basis in the stock, provided they have held the shares for five years. In order for the exclusion to apply, both the shareholder and the company must satisfy a number of requirements.
Shareholder Requirements for QSBS
The shareholder must receive shares from the company either in exchange for money (or other property) or as compensation for services; a shareholder generally cannot purchase shares from a pre-existing shareholder and still obtain the QSBS benefits. Section 1202(c). In addition, the shareholder must acquire the shares before the company has more than $50 million of “aggregate gross assets.” This means the company cannot have raised more than $50 million in funding rounds in addition to the adjusted basis of the company’s assets. Section 1202(d)(1). Finally, for substantially all the taxpayer’s holding period, the company must use 80% of its assets in a “qualified trade or business.” Section 1202(c)(2).
Company Requirements for QSBS
To be considered a “qualified trade or business,” the company must meet a number of requirements. First, the exclusion only attaches to shares issued by a C corporation; S corporations and businesses taxed as partnerships cannot issue QSBS. Section 1202(c)(1). Second, no more than 10% of the value of the company can be composed of real estate or stock and securities. Sections 1202(e)(5) and (e)(7). Finally, Section 1202(e)(3) states that the company cannot be engaged in roughly 20 specific types of business, including the performance of services in the fields of health, law, financial services, brokerage services, as well as any banking, insurance, financing, leasing, investing, or similar businesses.
Interestingly, despite the statutory proscription on certain industries as qualified trades or businesses, the IRS has issued four favorable private letter rulings (PLRs) since 2014 regarding the “qualified trade or business” limitation. In each of the four rulings, the IRS determined that the company was a qualified trade or business even though it was in one of the listed fields (three of the companies were in the “health” field and one was in the “brokerage” field).
The IRS appears to take the position that even if the company is in one of the listed fields, it could still be a qualified trade or business provided it is not simply delivering services. Rather, if the company’s “activities involve the deployment of specific manufacturing assets and intellectual property assets to create value for customers,” such a company can be a qualified trade or business even if listed at Section 1202(e)(3). PLR 201436001 (Sept. 5, 2014). In addition, PLR 202114002 (Jan. 13, 2021) helps confirm that shares of fintech and Insurtech companies are likely privy to QSBS benefits, expanding the exclusion’s applicability to a wider range of Silicon Valley startups.
Biden Increases to Long-Term Capital Gains
So how bad could the Biden tax increases be? Currently, shares subject to the long-term capital gains rate (i.e. stock held for more than one year) are taxed at 23.8% (including the 3.8% net investment income tax). The Biden administration proposed increases would tax long-term capital gains for earners with an adjusted gross income of more than $1 million at a new top marginal rate of 39.6%. With the 3.8% net investment income tax, the total federal long-term capital gains tax rate would be a whopping 43.4%. That means that startup founders and investors based in California would pay more than half of the total proceeds (56.7%) from the sale of their shares to the federal and California tax authorities.
Future QSBS Considerations
For founders and investors in startups, the proposed Biden capital gains significantly increase the importance of QSBS. The most serious risk is that the Biden administration will repeal QSBS benefits. Luckily, the Treasury Department’s Green Book states unequivocally: “the exclusion under current law for capital gain on certain small business stock [will continue to] apply,” (p. 63). Thus, at least for now, shareholders holding QSBS do not need to worry that the administration will revoke their Section 1202 benefits.
Still, with the prospective tax increases looming, founders and investors will certainly want to leverage and optimize QSBS. With IPOs of many fintech companies including Coinbase and Robinhood, as well as the rise of SPAC acquisitions, many founders, early employees, and investors hold QSBS in excess of $10 million.
For these shareholders, there are a number of methods to stack the QSBS exclusion in excess of $10 million. As a general matter, Section 1202 allows each “taxpayer” to exclude gain and the statute provides a number of avenues to create additional taxpayers who can exclude gain.
First, Section 1202(h)(2) allows shareholders to gift QSBS to other taxpayers who can take advantage of their own $10 million exclusion. So, for example, a founder who has $20 million worth of QSBS, can gift $10 million of shares to her child and then each founder and child can exclude their respective $10 million on the sale of the shares. Of course there are estate and gift tax implications to such gifts. But ideally, the founder can gift shares when the value is still low. In addition, founders can establish irrevocable non-grantor trusts for the benefit of their children or other relatives, and each of the trusts should receive its own $10 million exclusion after the founder transfers shares.
In addition, Section 1202(b)(3) appears to allow spouses who file jointly to exclude $20 million of QSBS. There are a number of situations in the tax code and IRS administrative guidance where spouses are treated as separate taxpayers. Since Section 1202 allows the $10 million exclusion on a per taxpayer, rather than a per tax return basis, it appears that spouses who are both founders (or both early investors in startups) should be able to exclude a total of $20 million of QSBS on a joint return.
QSBS and California Tax
Finally, it bears noting that while QSBS is excludable for federal tax purposes, California does not provide for a QSBS exclusion from state income tax. In 2012, a California appellate court found the California QSBS provisions unconstitutional. Thus, even if California founders and investors can avoid the Biden capital gains increases with QSBS, they will still pay California income tax on the sale of their shares.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Christopher Karachale, partner, and Imani Buckner, summer associate at Hanson Bridgett LLP.
Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.