Early Stage Investing Gets Favored Tax Treatment

Source: Alan Patricof, Managing Director, Greycroft Partners

In December 2015, Congress passed the PATH Act (Protecting Americans from Tax Hikes), a sweeping $1 trillion bill which, as part of an 887-page omnibus, would prove challenging for even the most astute of human beings to absorb, let alone many of those in Washington.

Nevertheless, page 813, Section 126, makes reference to a feature that’s now become a permanent part of the tax code — and it’s great news for entrepreneurs and other individuals financing startups and companies in the earliest stages of growth, as well as general partners and individual investors in venture capital funds. This is all part of Congress’ interest in encouraging long-term investing.

The impact this change will have on entrepreneurs, the lifeblood of the U.S. economy, is significant. This new code will enable a company’s founders and employees holding stock, including that obtained upon exercise of options, to save up to millions of dollars in taxes upon a company achieving a successful liquidation event.

Risk-taking entrepreneurs and investors who create jobs through building businesses will be rewarded for their efforts with lessened tax burdens. In this case, the disruptive innovation is a line of tax code rather than software code.

Known as Sec. 1202, it’s a small-business stock capital gains exclusion that has actually been around since 1993 (with modifications over the years). But thanks to Congress’ recent vote to PERMANENTLY extend some major tax benefits, it is more powerful than it has ever been because it eliminates all ambiguity.

In essence, Sec. 1202 allows individual investors or entrepreneurs and their employees who put money into a qualifying corporation with aggregate gross assets not exceeding $50 million before and immediately after the stock issuance, and which does not engage in repurchasing any of their outstanding stock, to now enjoy a 100 percent tax break on the specific investment gain with no offset to the benefit from the Alternative Minimum Tax (AMT).

The investment must be held for a minimum of five years. Certain language is usually inserted into the purchase documents of the investee corporation to attest that it is a Qualified Small Business Stock (QSBS) at the time of investment, and that it will continue to remain a QSBS — which is not hard to achieve.

It is difficult to overstate the magnitude of what this means for individuals who are founders or who invest in early stage corporations. In 2014 alone, 1,635,000 firms filed tax returns with the IRS with gross assets of less than $50 million.

According to PitchBook, 1-3,000 companies each year receive startup financing from venture capital firms. According to The University of New Hampshire Venture Research Center, on average, 70,000 companies are financed through angel networks annually — many, if not most, of whom would qualify for Sec. 1202 treatment.

Uncle Sam has thrown a huge bone to early stage investors and founders.

Each of these organizations has multiple employees and investors who also stand to benefit. With the enhancement of Sec. 1202, it has the further benefit — not to get too technical, but it is extremely important — of being able to take advantage of Sec. 1045, which allows one to shelter the proceeds from the sale of Sec. 1202 stock if, within 60 days, it is reinvested in another QSBS stock and thus begin a chain of deferring gains indefinitely. This combination can therefore have the compounded benefit of firmly establishing QSBS status for a corporation.

In addition, while in a typical venture capital fund, most, but not all, participants are pension funds, endowments and other institutions that are not subject to taxes of any sort, almost as important are the individuals who invest in the funds, including the general partners of these funds who typically contribute anywhere from 2-10 percent of a fund’s total assets.

Sec. 1202 provides that the amount of the gain that can be excluded from taxation for an individual is the greater of either 10 times the investment or $10 million for each specific qualifying investment made by the fund. Spread over multiple investments, the tax-free gain could be dramatic.

The impact of Sec. 1202 can be profound for an entrepreneur founding a company. If an entrepreneur incorporates and operates his or her company in adherence with Sec. 1202, the future tax savings could be as much as $2.4 million, or much more for investors (see exhibit at end of article).

Consider an entrepreneur who founds a company and at incorporation purchases his or her equity for $1, utilizing Sec. 1202 rather than simply granting it to themselves, as is commonplace at company formation.

For example, if the company is acquired more than five years later for $60 million and the founder owns 25 percent of the company at acquisition after raising outside capital from investors, he or she would earn $15 million in total proceeds from the sale. Typically, all $15 million of his or her proceeds would be subject to long-term capital gains, for a total tax burden of approximately $3.6 million.

However, if the company’s stock qualified under Sec. 1202, $10 million of these proceeds are exempt from taxation, reducing the total taxable gain to $5 million. Subjected to long-term capital gains of 20 percent and the federal net investment income tax of 3.8 percent, the total federal tax burden is approximately $1.2 million. Our savvy founder saved $2.4 million in taxes by taking advantage of Sec. 1202!

For the sake of demonstration, this example assumes the founder does not invest any of his or her own capital into the business — if they did, the implicated tax savings could be far greater. The same treatment would apply to employees exercising stock options that qualify.

In this case, the disruptive innovation is a line of tax code rather than software code.

Section 1202 has special significance to me because I was part of a national group who, in the early 1990s, created an organization known as Entrepreneurs for Clinton-Gore, back when Bill Clinton was running for president. We made certain proposals for tax incentives on behalf of those in small businesses; out of those efforts, Sec. 1202 was born.

But over the years, people stopped paying attention to the provision. Among other things, Congress passed various tax packages that eroded Sec. 1202’s advantages, especially as they related to the AMT restrictions. But now, thanks to an earlier bill Congress passed, the gains enabled by Sec. 1202 are no longer considered a “special preference” for the AMT.

To be sure, we do see a lot of losses in early stage investing, and most times investments are sold long before five years have elapsed — another aspect of Sec. 1202 that the National Venture Capital Association is working to get Congress to consider changing, in addition to establishing firm rules of eligibility to avoid foot faults.

If one is fortunate enough to start or participate in winning companies, Uncle Sam has with the passage of the PATH Act thrown a huge bone to early stage investors and founders. Hopefully with the passage of PATH. more individuals, including founders, angels, crowdfunders, employees and venture capitalists will more diligently consider Sec. 1202 benefits with their lawyers or accountants before completing their investment to see if it qualifies.

About Scale Finance

Scale Finance LLC (www.scalefinance.com) provides contract CFO services, Controller solutions, and support in raising capital, or executing M&A transactions, to entrepreneurial companies. The firm specializes in cost-effective financial reporting, budgeting & forecasting, implementing controls, complex modeling, business valuations, and other financial management, and provides strategic help for companies raising growth capital or considering M&A/recapitalization opportunities. Most of the firm’s clients are growing technology, healthcare, business services, consumer, and industrial companies at various stages of development from start-up to tens of millions in annual revenue. Scale Finance has multiple offices in the Carolinas including Charlotte, Raleigh/Durham, Greensboro, and Wilmington with a team of more than 45 professionals serving more than 120 companies throughout the region.