Biden's QSBS tax plan would have unintended consequences for startups

Buried deep in President Joe Biden’s 2021 tax plan are new amendments to the United States’ Qualified Small Business Stock (QSBS) program, which, if passed, will directly impact early-stage startup employees, founders and investors.

Lawmakers say the proposed changes to QSBS are designed to raise taxes on America’s millionaires and billionaires. But the net they’re casting is so wide that it will undoubtedly catch rank-and-file startup employees, who can easily (and temporarily) find themselves pushed into the country’s top tax bracket if they exercise stock options or sell their shares.

Congress should immediately reconsider these changes.

We fear that these unintended consequences could choke innovation and harm a small group of people while raising what will amount to a rounding error’s worth of new tax revenue for the federal government.

If you’ve exercised stock options in an early-stage startup at any point in the last five years, the proposed QSBS change may affect you when you decide to sell your shares in an exit. You might even be holding QSBS-qualifying stock without even knowing it.

Lawmakers want to reduce the QSBS gain exclusion rates to 50% for people who report more than $400,000 in adjusted gross income in a single year, and trusts and estates holding QSBS shares.

The QSBS exemption was initially enacted in 1993 as a tax incentive for small business owners, their investors and early employees.

Most technology startups begin life as QSBS-qualifying companies, and there can be significant tax benefits to founders, early-stage investors and early employees if they earn or exercise stock options during a startup’s earliest years.

For example, let’s imagine an engineer who joins a seed-stage software startup and is granted 200,000 stock options at $1 per share. The engineer exercises their stock options early, while the company has raised less than $50 million in venture capital.

Six years later, the startup gets acquired, and the engineer’s 200,000 shares are now worth $10 million.

Under current tax law, the engineer would be able to avoid paying an estimated $2.3 million in federal capital gains taxes under the QSBS exemption — $1.96 million in long-term capital gains (20%), and $372,400 in Net Investment Income Tax (3.8%).

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

The remaining $5 million would face taxes of nearly $1.6 million — $1.25 million in long-term capital gains (25% under the current proposal), $190,000 in Net Investment Income Tax (3.8%) and $150,000 of a newly proposed high-income surcharge tax.

Congress says they’re targeting America’s wealthiest people by rolling back the QSBS exemption.

In practice, the QSBS exemption has been popular with startup founders, investors and startup employees — people who take significant financial risks to fuel the startup ecosystem. QSBS was originally designed to reward those of us who drive the country’s innovation engine.

Effectively chopping this tax exemption in half will needlessly choke the innovation ecosystem, while raising an estimated average of $570 million per year in new tax revenue over the next decade, according to an analysis of federal data by QSBS Expert. That’s an inconsequential amount compared to the nation’s $3.5 trillion infrastructure plan.

The result will be a slight uptick in new federal revenue, taken from a relatively small group of people working in the innovation economy, and not worth the potential damage to startups. The QSBS exemption must be protected.

(Note: QSBS only applies to a specific set of small businesses and startups and requires people to earn or exercise their stock options while the company is still relatively small, and hold onto their shares for at least five years before selling them. Work with a CPA to find out if your shares qualify.)