US exclusion for small business capital gains

The Protecting Americans from Tax Hikes (PATH) Act of 2015 was recently signed into law by the US President Obama, and one provision (section 126) in particular benefits venture capital, private equity, and other investors owning or planning to purchase a US corporation.

Background

Non-corporate US taxpayers who acquire qualified small business (QSB) stock in a US corporation at original issuance, hold such stock for more than five years, sell such stock at a gain, and meet other requirements, may exclude all or a portion of that gain from taxable income. Without this exclusion, the gain from the sale of the stock is generally subject to capital gains tax in the hands of the US taxpayers.

Requirements

To qualify, the US corporation must use at least 80% of its asset value in the active conduct of one or more ‘qualified trades or businesses’ and it must not be engaged in an ineligible business (e.g. service business, financial, farming, natural resources, hotel, and restaurant businesses). In addition, the corporation’s aggregate gross assets must not exceed $50m up until and immediately after the original stock issuance. Many companies in the new and emerging technology sector are potentially eligible to issue QSB stock. Contractual language is commonly inserted into the purchase documents of the investee corporation to confirm that its stock is QSB stock at the time of investment, and that it will continue to remain so – not a particularly high threshold.

Although in a typical US venture capital fund most, but not all, investors are US and non-US pension funds, endowments and other institutional investors that are tax-exempt, the individual investors in the funds, including the general partners, typically contribute 2–10% of a fund’s total assets. Each individual taxpayer can exclude up to the greater of $10m or ten times the tax basis the taxpayer had in the QSB stock when it was first acquired. The $50m limitation, coupled with the ten times basis limitation, yields a potential exclusion of up to $500m of gain for each eligible shareholder, making the QSB stock exclusion extremely attractive.

As an added tax incentive, no portion of the gain excluded by reason of the 100% exclusion is subject to the US federal alternative minimum tax. In addition, to be treated as QSB stock, the stock generally must be acquired at its original issue (directly or through an underwriter). Stock purchased from a pre-existing shareholder is not eligible.

Non-corporate US taxpayers who acquire and hold QSB stock for more than six months (rather than five years) may elect to defer gain on the sale of the QSB stock by reinvesting the sale proceeds, within 60 days, into new QSB stock. The taxpayer’s basis in the new QSB stock is reduced by the amount of deferred gain. These deferral provisions were not affected by the PATH Act.

The QSB provisions are of great significance to the US founders and early stage investors. According to the IRS, in 2014, 1,635,000 firms filed tax returns with the IRS with gross assets of less than $50m. According to PitchBook, 3,000 US companies each year receive startup financing from the US venture capital firms. According to The University of New Hampshire Venture Research Center, on average, 70,000 companies are financed through angel networks every year most of which should qualify under the new QSB provisions.

Example

Consider an entrepreneur who founds a company and at incorporation purchases her equity for $1 rather than simply granting it to herself, as is common in the US.  If the company is acquired more than five years later for $60m and the founder owns 25% of the company at acquisition after raising outside capital from investors, she would earn $15m in total proceeds from the sale. Typically, all $15m of her proceeds would be subject to long-term capital gains, for a total tax burden of approximately $3.6m.

However, if the company’s stock is QSB stock, $10m of these proceeds is exempt from taxation, reducing the total taxable gain to $5m with the total federal tax burden is approximately $1.2m. The founder saved $2.4m in taxes by taking advantage of the QSB provisions.

This example assumes the founder does not invest any of her own capital into the business. If she did, the tax savings could significantly higher. The same treatment would apply to employees exercising stock options that qualify.

What does this mean?

QSB stock tax incentives provide an attractive motivation for:

• new US non-corporate investors to acquire stock in qualifying ventures (whether directly or indirectly through investment funds or other flow-through entities);
• holders of convertible debt, stock options and warrants issued by qualifying US ventures to consider exercising their conversion or purchase rights; and
• US entrepreneurs to consider organising their ventures as corporations in the first instance.

Although QSB stock tax treatment may be a factor in the initial choice of entity determination, the determination requires an in-depth examination of both tax and non-tax considerations. Non-corporate US investors in small businesses should be aware of this potential tax advantage, and should consider structuring their US investments with the QSB stock gain exclusion in mind.

Such investors should also weigh the benefits of the exclusion against the benefits of flow-through US taxation when choosing entity structure. Additionally, US investors must consider whether a currently held investment might qualify under the rules in the event of a sale of stock.

Substantial anecdotal evidence exists from emerging growth and venture capital US community, that QSB stock tax incentives stimulate the US start-up ecosystem by motivating entrepreneurial activity, innovation and investment in early-stage enterprises.