If the House proposal survives the lobbying onslaught, the beneficiaries of QSBS would still pay a significantly lower rate than other investors on non-QSBS gains or than workers on their wages. Karachale calculates the provision would raise the federal tax rate on a $10 million QSBS gain to almost 17%, up from 0% currently.
House Ways and Means Chairman Richard Neal “wholeheartedly rejects the notion that stock sales taxed at this rate would have any effect on innovation and investment,” a Ways and Means Committee Democratic aide said. “He believes that Silicon Valley millionaires making these disingenuous arguments are among the extremely wealthy people who should be contributing more, not less, to support investments in critical infrastructure and services that make success in this country possible.”
Speaker Nancy Pelosi and California Democratic congressman Ro Khanna, who represent large swathes of the San Francisco Bay Area, declined to comment.
To qualify as QSBS, the shares must be acquired before a startup hits $50 million in gross assets, a cut-off that often includes investors in seed, series A and series B funding rounds, as well as founders and earliest employees. Only businesses that file their taxes as C-corporations qualify — a rule that includes Silicon Valley startups but excludes most other smaller businesses, which tend to be S-corporations or other passthrough entities.
Small businesses, and many large ones, aren’t C-corporations because that requires companies pay a second layer of tax to the IRS at the corporate level, before shareholders are levied taxes on their dividends and gains. Passthrough businesses, by contrast, pay taxes once, on their owners’ individual returns. There are advantages to the C-corp status, however, when a company is destined to either go public or get acquired, which is why they’re the favorite structure for startups in software, biotech and other hot areas.
Technically, there are limits on how much QSBS gains can be shielded from taxes — capped at either $10 million or ten times an initial investment, whichever is more. But Silicon Valley accountants and lawyers have found a way around this: By putting QSBS in several trusts, startup founders and funders can multiply their tax-free gains, from just $10 million to $40 million or $50 million. “Every single person walking down University Avenue [in Palo Alto, California] has two or three irrevocable non-grantor trusts funded with QSBS,” Karachale said.
The Joint Committee on Taxation estimates the proposed limits on QSBS would raise an extra $5.7 billion over the next decade. But Manoj Viswanathan, a professor at the University of California, Hastings law school in San Francisco, has researched the issue and said those estimates “could be off by an order of magnitude,” underestimating how much startup founders, investors and early employees end up saving via the QSBS break.
Karachale agreed, saying the scorekeeper may not realize how popular and ubiquitous QSBS has become in Silicon Valley — and how many lucrative startups have come into the money. See, for example, the wave of special purpose acquisition companies, or SPACs, going onto the stock market, and the boom in fintech offerings including Coinbase Global Inc. and Robinhood Markets Inc.
“Everybody is going through that assuming they’re getting QSBS,” Karachale said.
An excess of capital that’s waiting to be deployed means QSBS is “just a giveaway,” said Viswanathan of UC-Hastings. “It’s a windfall for Silicon Valley as opposed to an incentive.”
But advocates say the point of QSBS is to encourage entrepreneurs and boost innovation.
“This provision does not appreciate the delicate balance that has made us the epitome, and Silicon Valley the literal home, of high risk/high reward entrepreneurship,” said Ashmeet Sidana, founder of Engineering Capital, which invests in technology companies, in Mountain View, California. He said limits on QSBS would reduce rewards for “investors who enable innovation and long-term building, versus speculators who don’t really enable innovation.”