After weeks of discussion, Congress remains at a standstill in the fight to advance both the bipartisan infrastructure bill and the proposed $3.5 trillion reconciliation package, with some legislators concerned about the size and scope of the packages. Revenue raisers in the form of tax increases have centered the reconciliation debate. But another proposed provision — to alter the favorable treatment of qualified small business stock (QSBS) — should be on startups’ radars.
Section 1202 of the Internal Revenue Code encourages investment in qualified small businesses. Only certain businesses can be designated as a qualified small business — namely, C corporations that have less than $50 million in assets at the time stock is issued that use 80% of capital for business operations. Under a bipartisan incentive first introduced in the early nineties, those holding QSBS are able to limit capital gains taxes if they meet certain conditions, including holding the stock for at least five years. This little-talked-about provision is a useful tool in startups’ and investors’ toolboxes and helps draw funds, like angel investment, toward nascent ventures. The provision serves as an incentive to invest in riskier startups — ones that don’t hold the certainty that mature companies often do — and enables startups to supplement compensation packages, particularly in their early days when profitability may limit salaries.
To help offset the cost of the reconciliation package, Democrats have proposed curtailing the QSBS tax treatment for earners over $400,000 or more, for any relinquishment of stock occurring after September 13, 2021, affecting both new QSBS holders and those who already held stock. Employees that received QSBS as part of their compensation in joining a new, unproven company could be harmed, and the change would give potential investors one more reason to refuse to take on the risk of financing a fledgling company.
Policymakers should be wary of pursuing any efforts that limit financing new companies, especially as the U.S. emerges from the pandemic. Instead of crafting legislation that erects further barriers to capital access and new business formation during a period of economic recovery, Congress should look for ways to expand access to innovation. Investors who fund qualified small businesses use returns to, in turn, reinvest further into qualified small businesses, including those outside traditional startup hubs like Silicon Valley. Curtailing QSBS treatment will only hurt the small businesses that fuel the American economy and harm workers that often forgo increased salary potential to bet on the success of a novel startup.
