Biden's QSBS Tax Plan: Potential Risks for Startups

Amendments to the Qualified Small Business Stock Program

Within President Joe Biden’s 2021 tax proposals lie revisions to the United States’ Qualified Small Business Stock (QSBS) program. These alterations, should they be enacted, will have a direct bearing on employees, founders, and investors in early-stage startups.

Tax Implications for Startup Participants

Legislators state that the intended effect of changes to QSBS is to increase taxation on high-net-worth individuals in the United States. However, the scope of these changes is broad. Consequently, they risk impacting typical startup employees who may temporarily find themselves in the highest tax bracket upon exercising stock options or selling shares.

A Call for Reconsideration

We believe Congress should promptly reassess these proposed modifications. The potential for unintended negative consequences – stifling innovation and negatively affecting a limited group – outweighs the minimal increase in federal tax revenue they are projected to generate.

Potential Impact on Existing Shareholders

If you have exercised stock options within an early-stage startup in the past five years, these proposed QSBS changes could influence your tax liability when you eventually sell your shares following an exit. It’s even possible you currently hold QSBS-qualifying stock without realizing it.

Proposed Changes to Gain Exclusion Rates

The proposed legislation seeks to reduce the QSBS gain exclusion rates to 50% for individuals reporting adjusted gross income exceeding $400,000 annually, as well as for trusts and estates that hold QSBS shares.

Historical Context of the QSBS Exemption

The QSBS exemption was originally established in 1993. It was designed as a tax incentive to encourage investment in small businesses, their investors, and their earliest employees.

QSBS and Technology Startups

The majority of technology startups initially qualify for QSBS status. Significant tax advantages can be realized by founders, early investors, and employees who earn or exercise stock options during the startup’s formative stages.

Illustrative Example: Engineer’s Stock Options

Consider an engineer who receives 200,000 stock options at $1 per share when joining a seed-stage software startup. The engineer exercises these options while the company has raised less than $50 million in venture capital.

Acquisition and Potential Tax Savings

After six years, the startup is acquired, and the engineer’s 200,000 shares are valued at $10 million. Currently, the engineer could potentially avoid approximately $2.3 million in federal capital gains taxes through the QSBS exemption. This includes $1.96 million in long-term capital gains (20%) and $372,400 in Net Investment Income Tax (3.8%).

Impact of Proposed Changes on the Example

Under the proposed tax code changes, the engineer would only be able to exclude half of their profits from federal capital gains taxes using the QSBS exemption.

Increased Tax Burden Under New Regulations

The remaining $5 million would be subject to taxes totaling nearly $1.6 million. This breaks down to $1.25 million in long-term capital gains (25% under the proposal), $190,000 in Net Investment Income Tax (3.8%), and an additional $150,000 from a proposed high-income surcharge.

Legislative Intent vs. Practical Effects

Congress asserts that these changes are aimed at the wealthiest Americans by curtailing the QSBS exemption. However, in practice, the exemption is widely utilized by startup founders, investors, and employees – individuals who assume substantial financial risks to support the startup ecosystem.

Potential Damage to Innovation

Reducing this tax exemption by half will unnecessarily hinder the innovation ecosystem. It is projected to generate an estimated $570 million in new tax revenue annually over the next decade, according to an analysis by QSBS Expert. This amount is relatively insignificant compared to the nation’s $3.5 trillion infrastructure plan.

Protecting the QSBS Exemption

The outcome will be a modest increase in federal revenue, derived from a limited segment of the innovation economy. This is not commensurate with the potential harm to startups. The QSBS exemption must be preserved.

Important Disclaimer

(Please note: QSBS applies only to specific small businesses and startups. Individuals must earn or exercise their stock options while the company remains relatively small and hold their shares for at least five years before selling them. Consult with a CPA to determine if your shares qualify.)