Silicon Valley woke up last week to a surprise: A tax break that lets the tech industry’s millionaires and billionaires shield their winnings from the Internal Revenue Service is being targeted by Democrats in Washington.
Once an obscure provision of the tax code, “qualified small business stock,” or QSBS, benefits venture capital-backed start-ups in technology and other industries that are aiming to get very big, very quickly. If these young companies go public or get acquired, holders of their QSBS pay no capital gains taxes on windfalls of $10 million or — in some cases — even more. And despite its name, the vast majority of small businesses can never qualify for the tax break.
The tax proposal approved by the House Ways and Means committee last week wouldn’t kill off QSBS entirely. Instead, it would cut in half the amount that QSBS can exclude from taxes. To critics, QSBS is expensive and unnecessary, a reward for investment that would have happened anyway—and one that benefits some of the richest people in the world, many of whom supported Joe Biden’s presidential bid and the Democratic takeover of Congress.
The U.S. Treasury “Green Book,” a collection of revenue-raising proposals released earlier this year, seemed to indicate that President Biden’s administration wouldn’t touch QSBS. Then the Ways and Means plan released on Sept. 13 included the QSBS restrictions on page 628 of 881. They would apply only to taxpayers whose income is $400,000 or more, but that should cover almost everyone cashing in QSBS shares.
“People felt like they got sideswiped. It’s really a surprise. We didn’t see this coming at all,” said Christopher Karachale, a partner at the law firm Hanson Bridgett LLP in San Francisco who is an expert on the break.
Because the legislative text said the change applied to transactions “after Sept. 13,” some holders of QSBS told Karachale they were rushing to sell their shares that day, hoping they could still claim the full tax break on next year’s 1040 form. There were “a lot of people freaking out,” he said.
Investors in tech and other startups still hope to stop the change.
“We’re mobilizing all the resources we’ve got,” said Angel Capital Association CEO Patrick Gouhin, who argued QSBS is especially valuable for incentivizing “high risk” early-stage investments. “This can be devastating to the startup ecosystem. This is going to make it more challenging for entrepreneurs to find the capital they need to grow their companies.”
If the House proposal survives the lobbying onslaught, the beneficiaries of QSBS would still pay a significantly lower rate than other investors on non-QSBS gains or than workers on their wages. Karachale calculates the provision would raise the federal tax rate on a $10 million QSBS gain to almost 17%, up from 0% currently.
House Ways and Means Chairman Richard Neal “wholeheartedly rejects the notion that stock sales taxed at this rate would have any effect on innovation and investment,” a Ways and Means Committee Democratic aide said. “He believes that Silicon Valley millionaires making these disingenuous arguments are among the extremely wealthy people who should be contributing more, not less, to support investments in critical infrastructure and services that make success in this country possible.”