Silicon Valley has won big with a tax break aimed at small businesses.
Early investors and employees at Uber, Lyft, and other tech companies are getting a double reward this year: a wave of initial public offerings that puts billions of dollars in their pockets, and a quirk in the law that means some of that money will be tax-free.
Entrepreneurs, venture capital firms, and early startup employees are using the Qualified Small Business Stock, or QSBS, provision to partially or totally wipe out their tax bills. “It’s an awesome way to mitigate tax,” says Richard Scarpelli, head of financial planning at First Republic Private Wealth Management. Of all the strategies that investors and business owners use to lower capital-gains taxes, he says, “this is by far the best.”
Shares are eligible for QSBS if they’re issued when a company has gross assets of $50 million or less. If you hold on to the stock for at least five years, you can avoid taxes on $10 million of any gains when you sell. But that $10 million is only a minimum—the law says you can instead shield as much as 10 times your initial investment, or basis, in the corporation. So a venture firm that put $10 million in an early startup could reap $100 million in tax-free gains. And QSBS’s benefit can be multiplied several-fold with clever planning.
The incentive was created after the recession of the early 1990s and expanded during the financial crisis that began in 2008. It’s supposed to help young companies attract capital. The congressional Joint Committee on Taxation says the provision costs the U.S. Treasury $1.3 billion a year. “There is no evidence that these sorts of breaks do anything to help the economy in the long run,” says Steve Wamhoff, director of federal tax policy at the left-leaning Institute on Taxation and Economic Policy. “Even in the short run, they are likely to reward investments that would have happened anyway.”
The vast majority of small businesses aren’t eligible for the break because they’re organized as pass-throughs, which have their income reported on owners’ individual tax returns. Only C-corporations, which file their own corporate returns, qualify for QSBS. The tech industry is the prime beneficiary. Venture-backed companies tend to be organized as C-corporations, and in the past decade hundreds of tech startups have seen the sort of rapid growth that makes QSBS so lucrative. …
The bad news for many tech billionaires is they may still owe California taxes on their gains. The home of Silicon Valley, which taxes its richest residents at rates as high as 13.3%, is one of just a few states that doesn’t recognize QSBS. In most of the rest of the country, QSBS will exclude both federal and state taxes. …
The tax law signed by President Donald Trump in 2017 is bringing QSBS to the attention of more investors. By slashing corporate tax rates, Trump’s tax reform makes the C-corporation structure more attractive to entrepreneurs outside technology, Dillon says. Still, that doesn’t mean lawmakers can’t take the benefit away in the future—a 2014 proposal floated by then-House Ways and Means Chairman Dave Camp, a Republican, would have eliminated the QSBS provision to simplify the tax code. “There’s legislative risk with this,” says Brandon Smith, director of estate planning at Wetherby Asset Management. “If you’re getting into something now, who’s to say the benefits will be there five years from now?”