One of venture capital’s most popular tax breaks could be cut – Crunchbase News



When President Joe Biden unveiled his U.S. plan for families in the spring, many venture capitalists appeared to shrug their shoulders.

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Sure, the capital gains tax was about to increase – from 20% to 39.6% for high earners – but their preferred tax break as investors seemed almost certain not to be hit. .

A lot can change in Washington, DC in five months.

Earlier this month, the House Ways and Means Committee approved a tax proposal that would cut in half the amount that investors who invest under the Qualified Small Business Stock (QSBS) tax provision can exclude.

While it is far from safe to get into QSBS, it seems certain that many venture capitalists will remain nervous watching what Washington does next.

“There is still a lot to be done about this,” said William Yahara, tax director at EisnerAmper. “There is a lot of lobbying going on. “

What is QSBS?

While QSBS may be an obscure tax law for the most part, many in Silicon Valley know this well. Under Section 1202 of the IRS Code, start-up investors who invest in QSBS – which includes tech startups as long as they are C companies – since 2010 are allowed to exclude 100% of earnings in capital realized on these investments, if the shares are held for at least five years and are acquired on issue.

The exclusion – signed under the Clinton administration and extended under the Obama White House – has a limit of $ 10 million or 10 times the basis of the shares sold, whichever is greater.

Despite the green paper released in May by the US Treasury Department that stated that the exclusion under current law of capital gains on certain shares of small businesses would also continue to apply, the House committee has reversed course this month and proposed reducing that tax break so that 50 percent of the capital gains from these investments would be excluded from tax.

The change comes as the federal government searches for easy ways to increase revenues, especially as Democratic lawmakers attempt to push through a $ 3.5 trillion infrastructure package. According to the Joint Committee on Taxation, Tax Amendment 1202 would bring in an additional $ 470 million next year, rising to $ 710 million by 2029. Although the tax increase has still not been approved, it would affect any investment sold by investors after September 13 of this year.

Investors are watching

As investors watch and wait, some worry about the proposed tax change and its impact on jobs and innovation.

Brian Gaister, co-founder and partner of Maryland-based SaaS Ventures, raised concerns about the effect the tax increase could have on small and medium-sized businesses looking to raise capital as the section 1202 was put in place to encourage investors to invest. in growing small businesses.

“This is an incentive that compensates investors for taking early risks, which ultimately led to significant job creation in this country and most importantly to scientific and technological advancements,” said Gaister, who is also co-founder and CEO of Maryland. based at Pennington Partners & Co.

Minimizing the benefits of QSBS also discourages investments in early tech companies and founders, Gaister argues.

It is also important to remember that the proposed changes to the QSBS Advantage have a direct impact on individual investors who often constitute the majority of early stage investment capital, compared to large institutional investors who traditionally invest at later stages. and therefore do not receive the QSBS benefit.

“A significant amount of startup investment comes from Taxable Investors (QSBS),” Gaister said. He added that this could affect the stage at which investors invest as they are not paid as much for the initial risk, and investors might just look to invest at a later stage, which would create a significant gap for companies in startups that require capital investment. .

The options remain

If the 1202 tax break is essentially cut in half, investors would have the option of investing their capital gains from prior agreements in other locations, which would reduce or delay the increased tax payments.

One option some investors may consider is Section 1045 of the code, which is essentially married to 1202, Yahara said. This arrangement allows investors to transfer their capital gains from a QSBS investment into a new investment that also meets QSBS parameters without being taxed.

However, to take advantage of this, investors must complete their new investment within 60 days and be able to prove that the original QSBS has been held for more than six months.

Another option that investors should at least defer paying for capital gains tax would be to invest in opportunity areas across the United States.

Opportunity Zones are federally designated areas located in low income areas. The tax-advantaged program is designed to offer significant incentives to invest in real estate development or in businesses that create new jobs to stimulate growth.

Gaister, who invests in Opportunity Zones, mentioned that the program allows investors with capital gains to defer tax payments until 2026 and also get a 10% discount – if they are invested this year, because the discount drops to 5% next year – with all the income. on the new investment in the Zone of Opportunity free of capital gains tax.

However, Yahara stressed that there is no one option for all investors.

“There is no one shoe that fits all,” he said, adding that it is also important to remember that there are a lot of investors who invest in venture capital funds. which are not affected by any changes to the QSBS rules, such as pensions.

Wait and watch

Yahara also reiterated that it is not entirely clear what the end result of the possible tax increase will be. He and others always take a wait-and-see approach to what Congress can do, he said.

With some important votes to come at the end of this month, Gaister said he and his company do not expect to know the precise outcome of the proposed QSBS tax increase for four to six weeks.

At the end of the day, it’s just another issue that founders and investors must learn to deal with, he added.

“In business, entrepreneurs are used to challenges,” he said. “You can only control what you can control.”

Illustration: Dom Guzman

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