Venture Capitalists May Lose Popular Tax Break as Congress Proposes Reduction in QSBS Exclusion

In recent years, tax incentives have become a popular tool for states and the federal government to encourage venture capital (VC) investment in under-served communities. However, as Congress is set to reconsider capital gains taxes as part of President Joe Biden’s ambitious $3.5 trillion infrastructure package, there is growing concern among venture capitalists regarding the future of Qualified Small Business Stock (QSBS) tax breaks.

Best Practices: Federal & State Tax Incentives for Venture Capital Investors

Tax policy as a means of encouraging angel investment in under-served communities According to an analysis by the Joint Committee on Taxation, halving the QSBS tax break, as proposed by the House Ways and Means Committee, would raise an additional $470 million in the coming year and $710 million by 2029. With investors permitted to exclude 100% of the capital gains made on early-stage investments under QSBS, many in Silicon Valley are anxious to see what action Congress will take.

What is QSBS?

Under Section 1202 of the IRS Code, QSBS investors have been permitted to exclude 100% of the capital gains made on their investments, so long as the stock is held for a minimum of five years and acquired at issue. This exclusion has a cap of $10 million or 10 times the basis of the stock sold, whichever is greater. The QSBS applies to C corporations, including tech startups, and was signed into law under the Clinton administration, with expansions made under the Obama White House. However, the House committee has proposed cutting the tax break, allowing only 50% of capital gains from investments to be excluded from tax.

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Options for Investors

If the tax break is cut, investors will be forced to seek other options for their capital gains from previous deals. One such option is Code Section 1045, which allows investors to roll their capital gains from a QSBS investment into a new investment that meets QSBS parameters without being taxed. Another option would be investing in Opportunity Zones, which are federally designated zones in low-income areas. The tax-advantaged program allows investors with capital gains to defer tax payments until 2026 and receive a 10% discount, dropping to 5% next year, while earnings on the new investment in Opportunity Zones are tax-free on capital gains.

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