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  • Biden Tax Changes Preserve QSBS Benefits: and Make the Exclusion More Valuable

Biden Tax Changes Preserve QSBS Benefits: and Make the Exclusion More Valuable

by Christopher Karachale, Partner, and Imani Buckner, Summer Associate

June 01, 2021

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On May 28, the Treasury Department released the General Explanations of the Administration's Fiscal Year 2022 Revenue Proposals, known as the "Green Book," detailing the Biden administration's proposed changes to the Internal Revenue Code (IRC). For startup founders and early investors, the Green Book provides welcome relief. The current administration does not intend to make any changes to IRC sections 1202 and 1045, which provide the statutory framework for the valuable benefits of Qualified Small Business Stock (QSBS). The Green Book states unequivocally: "the exclusion under current law for capital gain on the certain small business stock would also [continue to] apply." (p. 63)

As most investors now know, the QSBS rules provide significant tax efficiencies for founders, employees, and early investors in most technology startups. Provided a taxpayer invests in the startup before such business has $50 million in funding, the taxpayer can generally exclude up to $10 million or ten times her basis in the startup shares. Of course, IRC sections 1202 and 1045 contain various requirements regarding the nature of the business and a taxpayer's required holding period.  But the IRS continues to release favorable guidance regarding the QSBS rules. In fact, a recent IRS private letter ruling helps confirm that shares of Fintech and Insurtech companies are likely privy to the QSBS.

While the Green Book leaves QSBS untouched, it does contain many other provisions affecting founders and investors in startup businesses.

Important Biden Tax Changes affecting Startup Founders and Investors

Top Marginal Rate

Currently, the top marginal tax rate for individual taxpayers is 37 percent for unmarried taxpayers making over $523,600 and married taxpayers filing jointly with over $628,300 in taxable income. The new proposal would raise the top marginal rate to 39.6 percent beginning December 31, 2021, while lowering the threshold for the highest rate to $452,700 for unmarried taxpayers and $509,300 for married taxpayers filing jointly. Founders and other startup workers – especially those subject to ordinary income treatment on the conversion of their options in a merger transaction – will certainly feel this increase.

Long-Term Capital Gains Rate

More significantly, the Biden administration plans to raise the long-term capital gains rate drastically. Currently, the long-term capital gains rate 23.8 percent (including the 3.8 percent net investment income tax). The proposed rules will tax long-term capital gains for earners with an adjusted gross income of more than $1 million at the new top marginal rate of 39.6 percent described above, plus the net investment income tax. In sum, federal long-term capital gains will be taxed at a rate of 43.4 percent. In addition, the increase will be applied retroactively to the date President Biden first announced his proposal to Congress on April 28, 2021.

For startup shareholders going through a secondary sale or exit, the proposed Biden administration increases on long-term capital gain rates have draconian implications. Founders based in California and selling their companies will pay an effective tax rate of 56.7 percent (43.4 percent federal plus 13.3 percent California rates) on the sale of their shares. In other words, startup founders and investors will pay more than half the proceeds from the sale of their shares to the federal and California tax authorities. While such a result may benefit the federal and state fisc, it certainly makes a potential taxable sale of a company less appealing for founders and early investors.

In addition, the retroactivity of the provision could have perverse effects. Consider a founder who sold her (non-QSBS) company in May 2021, assuming she would get preferential long-term capital gain rates of 23.8 percent. She would not have sold but for these preferential rates. Now she learns that her planning was futile – she needs to pay the higher rates anyway. Such a regime seems to penalize founders without notice.

Increased Importance of QSBS

These Biden proposed rate increases mean that QSBS benefits will become even more important for founders and investors in the coming months and years. As an exclusion from gain, shareholders who hold QSBS are indifferent to the effective capital gains rate. Such shareholders can potentially exclude all federal gain on the sale of their shares with appropriate planning.

Of course, as QSBS exclusion claims become more prevalent, the IRS will need to provide additional guidance on various unresolved IRC section 1202 and 1045 issues. For example, is a couple whom each owns shares of QSBS entitled to a $20 million exclusion if they claim the exclusion in a married filing jointly return? Can taxpayers claim QSBS holding period while they own units of an LLC since IRC section 1223 holding period rules appear to override general QSBS holding period rules? How do taxpayers determine the "value" of a company's assets for the 80 percent active business test following the two-year working capital safe harbor?

These are just a fraction of the unanswered questions regarding the application of the QSBS rules. In this respect, it comes as no surprise that the American Institute of CPA's Recommendations for the 2021-2022 Guidance Priority List asks the IRS to provide specific guidance on various QSBS issues. Moreover, with increased capital gains rates, the stakes for proving out QSBS qualification for shareholders become even higher.

Taxpayers with questions about the Biden administration's proposed tax changes, QSBS, or raising Vizslas can contact Christopher Karachale, Imani Buckner, or the Hanson Bridgett Tax Group.

For more information, please contact:

Christopher Karachale

415-995-5863 Direct Phone
415-995-3407 Fax

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