When Congress enacted Section 1202, it noted that the earnings exclusion was intended to “encourage the flow of capital to small businesses, many of which have difficulty attracting equity financing.” When the percentage gain exclusion was raised to 100% in 2010, Congress noted that “the increased exclusion and elimination of the minimum tax preference for small business stocks will encourage and reward investment in small businesses. qualified actions of small businesses ”.
Proposed Reduction of the Section 1202 Percentage Exclusion
On September 13, 2021, the House Ways and Means Committee released a bill, called as part of the “Build Back Better Act,” which proposes to amend Section 1202 (a) to remove earning exclusions from 75 % and 100% for taxpayers. whose Adjusted Gross Income (AGI) is equal to or greater than $ 400,000, or which is a trust or estate.[i] All shareholders would still be eligible with the 50% gain exclusion of section 1202 applicable to QSBSs issued before February 18, 2009.
The various tax hikes included in the bill were introduced as a way to fund President Biden’s $ 3.5 trillion infrastructure spending bill. House Ways and Means Committee Chairman Richard Neal described the various tax increases proposed for high-income taxpayers as a way to “alleviate wealth inequalities and strengthen the progressive power of our system. tax by increasing the personal income tax rate, increasing the highest rate of surplus value, and adding a modest surtax on the wealthiest taxpayers.
Putting these various elements together, it appears that the benefits of Section 1202’s 100% earnings exclusion, which was presented by Congress in 2010 as an accelerator to encourage investment in risky start-ups , be counterbalanced in 2021 by the desire to generate tax revenue and “reduce wealth inequalities”.
The proposed legislation as currently drafted would come into effect for sales and trading of Qualified Small Business Shares (QSBS) occurring on or after September 13, 2021, subject to a binding contractual exception for contracts in effect. effective before September 13, 2021.
The proposed legislation includes several additional tax increases targeting high net worth and higher income taxpayers. Increasing the maximum capital gains rate from 20% to 25% and adding a new 3% surtax imposed on gross income over $ 5 million.[ii]
Potential impact of the proposed changes
Under current section 1202, a shareholder who has a gain of $ 10 million from the sale of QSBS is generally entitled to $ 2,380,000 in federal income tax savings after claiming the exclusion of 10 $ 1202 million – the difference between the 20% rate of capital gains and 3.8% investment income. tax and a 0% tax rate, no tax on investment income and no alternative minimum tax.[iii]
Under amended section 1202, the same shareholder claiming the 50% exclusion of earnings would generally be entitled to $ 1,590,000 in federal income tax savings – the difference between the 25% rate of capital gains plus tax on investment income of 3.8% plus additional tax of 3% on income over $ 5 million and a weighted tax rate of 15.9%.[iv]
Thus, for a shareholder who has $ 10 million in QSBS gain and claims the 50% gain exclusion, there is a reduction of approximately $ 790,000 in federal income tax savings resulting from the legislation. proposed on the basis of a rough comparison set out above.[v]
Factors to consider when choosing an entity
Clearly, the proposed tax legislation reduces the potential tax savings associated with investing in QSBS and likely reduces the incentive to invest in start-ups, but there continue to be significant benefits associated with selecting a business. ‘a C corporation instead of an S corporation or LLC. / LP for start-ups. The House Ways and Means Committee’s focus on raising taxes for high-income taxpayers may divert investments away from flow-through entities where taxpayers bear the annual burden of various higher rates and surcharges, in favor of corporations C whose tax rate remains competitive, assuming the business allows income to be reinvested rather than distributed as taxable compensation or dividends. The AC company is generally a tax efficient business entity if the income is reinvested in the business, thus avoiding double taxation, and shareholders successfully reap the benefits of their investment through a possible sale of the company. actions, especially if the section 1202 earnings exclusion is available.
At this early stage in the legislative process, remember that the path from the Ways and Means Committee bill to its enactment is unclear. Each of the proposed changes to tax laws is subject to change or abandonment during the legislative process. Finally, QSBSs issued today must be kept for five years before requesting the Section 1202 Earnings Exclusion. Over the years, Congress has made several changes to the Section 1202 Percentage Gain Exclusion. and a reduction today in the percentage gain exclusion could be followed in the next administration by a return of the 100% gain exclusion.
We plan to follow the proposed legislation as it travels through Congress and will supplement this article to address additional developments and planning considerations.