Small Businesses Rejoice!

Congress Makes Permanent the 100% Exclusion on Sales of Qualified Small Business Stock:
Founders and Early Investors May Sell Stock Tax-Free, Importance of Meeting QSBS Requirements Heightened

As an annual tradition, Congress passes a package of tax breaks that typically last 1 to 2 years and have come to be known as the “tax extenders.” That package includes a tax break for certain sales of “qualified small business stock” under Section 1202 of the tax code. Prior to the Great Recession, up to $10 million of gain on sales of qualified small business stock were eligible for 50% gain exclusion, but the other 50% — the taxed half — became ineligible for long-term capital gains rates. (Also, the excluded half was subject to the alternative minimum tax.) As a result, the blended tax rate on gains from QSBS was about the same as the tax rate on sales of non-QSBS, making Section 1202 largely dead wood.

Then, to stimulate the economy, Congress enhanced the Section 1202 exclusion by increasing the excluded portion to 75%. Unsatisfied, Congress increased the exclusion to 100% and removed the alternative minimum tax application. As a result, many founders and early investors qualify for a zero tax rate on gains from their corporate ventures and investments. If this seems shocking, it’s most likely because Section 1202 imposes a 5-year holding period requirement, and September 29, 2015 was the first date that 100%-exclusion QSBS could be sold tax-free (assuming such QSBS was purchased on the first qualifying day). In other words, very few people have yet had direct experience with the full exclusion and no tax returns reflecting this exclusion have yet been filed.

Nevertheless, Congress felt confident of the benefits of 100% exclusion (and unconcerned of any deleterious effect on the deficit) and today made the provision permanent. President Obama has indicated he will sign the legislation.

People can debate the merits of a tax provision that complete absolves shareholders of tax when they founded the venture or invested very early seed capital. Section 1202, however, applies to all investors that come in before the corporation’s assets exceed $50 million — not a small amount. So, at a time when many Americans are upset about the carried interest “loophole” granting private equity and hedge fund managers a 23.8% rate, Congress has granted a 0.0% tax rate to a privileged subset of venture capital investors.