Benjamin M. Willis (@willisweighsin on Twitter; firstname.lastname@example.org) is a contributing editor with Tax Notes. He formerly worked in the mergers and acquisitions and international tax groups at PwC and at the Treasury Office of Tax Policy, the IRS, and the Senate Finance Committee. Before joining Tax Analysts, he was the corporate tax leader in the national office of BDO USA LLP. Ryan J. Dobens is a CPA and attorney who specializes in partnership taxation and advises start-ups on the benefits of section 1202. He formerly worked as a director in PwC’s mergers and acquisitions tax group.
In this article, Willis and Dobens explain why it’s unlikely the House’s version of the Build Back Better Act will succeed in reversing Biden’s earlier efforts to expand the section 1202 exclusion from 50 to 100 percent.
Now that the House has passed the Build Back Better Act (H.R. 5376), the bill makes its way to the Senate for further consideration, possibly to become law. While the Biden administration has trumpeted the legislation as being able to “rebuild the backbone of the country,”1 it seems that rebuilding the American start-up wasn’t a top priority in this version of the bill.
Instead, changes to section 1202 would limit incentives for entrepreneurial start-up founders and their moonshot investors.2 Those changes, buried in section 138149 of the Build Back Better Act’s legislative text, reduce the exclusion of qualified small business stock (QSBS) gain from 100 percent to 50 percent for some noncorporate taxpayers that have adjusted gross income exceeding $400,000 during the year in which QSBS is sold.
It seems unlikely that President Biden will sign into law changes that reverse his hard-fought section 1202 victory that was designed to help America recover from the Great Recession by supporting small business workers at lower income levels and by offering incentives to those making more than $400,000 because their investments of capital and time “encourage the flow of capital to small business.”3
The QSBS gain exclusion was put into the tax code for a reason.4 Compared with large, well-established businesses, start-up companies inherently have a short business track record and often minimal credit history, which makes it difficult to obtain loans or other financing on reasonable terms.5 Having to compete with well-heeled businesses that can offer lucrative cash incentives also disadvantages start-ups when they’re trying to recruit top talent to foster their innovations. QSBS helps level the playing field by providing tepid investors with aspirational tax-advantaged investments and equity awards to entrepreneurial employees that might otherwise just opt to climb the corporate ladder. We believe that the QSBS exclusion helps improve parity for economically disadvantaged businesses, which was its intended purpose when enacted in 1993 and when the percentage exclusion was increased in 2009 and 2010.
Policymakers may believe that the QSBS gain exclusion provides an excessive incentive for some high-earning taxpayers. But it appears policymakers are forgetting that the true benefits of QSBS lie in the creation of jobs6 and the cultivation of aspiring businesses that may otherwise go unfunded.7 The House bill raises revenue by taxing some eligible founders and early investors to the tune of $5.7 billion.8 That tax could have the ancillary effect of dissuading future founders and investors from taking a chance on a start-up.
Before making drastic changes to the QSBS gain exclusion, policymakers should pause and consider the economic detriment of lost innovation along with the incremental revenue the legislation hopes to raise. However, if change is necessary, this article offers suggestions for keeping QSBS viable and perhaps giving it a new purpose. It will continue to be viable if the unexcluded QSBS gain tax rate conforms with today’s statutory capital gains rate (that is, 20 percent).9 Also, QSBS could draw itself a new purpose by adding restaurants to the menu, an industry hit harder than most by the COVID-19 pandemic.10
I. QSBS History and Technical Background
QSBS has its roots in Sen. Dale Bumpers’s 1991 legislative proposal that permitted a deduction for “taxpayers who make high-risk, long-term, growth-oriented venture and seed capital investments in start-up and other small enterprises.”11 The text of Bumpers’s bill seems to have been used as a framework for President Clinton’s 1993 budget proposal,12 which then became the Omnibus Budget Reconciliation Act of 199313 and made section 1202 the law of the land.
The legislative history confirms congressional intent to provide capital for “the startup and expansion of small and midsized businesses.”14 As originally enacted, section 1202 permitted noncorporate taxpayers a 50 percent exclusion from gross income for gain from the sale of QSBS (as long as numerous requirements were satisfied). But later, under the watchful eye of then-Vice President Biden, the relevant exclusion percentages for the QSBS exclusion were increased to 75 percent (for shares issued after Feb. 17, 2009)15 and again to 100 percent (for shares issued after Sept. 27, 2010)16 of otherwise eligible QSBS. Those later changes to the percentage exclusion breathed new life into the well-intentioned but, in the early days, practically ineffective QSBS incentive. The House now seeks to reduce the incentive to its ineffective beginnings.
B. Unwinding History
It seems odd that Congress would send Biden a bill that contradicts his long history of supporting start-up companies through the QSBS incentive. When signing the American Recovery and Reinvestment Act of 2009, former President Obama gave then-Vice President Biden credit for making the legislation possible because QSBS would build “the economy for the future” through job creation.17
Support for the QSBS gain exclusion also came from Sen. Chuck Grassley, R-Iowa, who explained that he supported the “proposal by President Obama to eliminate capital gains on sale of stock in small business and startup corporations.”18 He went on to explain that capital gain rate changes over the years had made the purpose of section 1202 “not very effective” and that the increase to the percentage exclusion was welcome.19 In December 2015 Obama signed into law the Protecting Americans From Tax Hikes (PATH) Act of 2015, which retroactively renewed and permanently extended the 100 percent QSBS exclusion. This legislation could be viewed as the culmination of Obama and Biden’s efforts to level the playing field for start-ups competing with large publicly traded corporations — an uphill battle to say the least.
While eliminating an exclusion like the one for QSBS isn’t surprising as an offset for spending goals, the Biden administration seems an unlikely prospect to toe the line because it would reverse Biden’s long-standing support of a worthy cause: start-up innovation.
C. QSBS Technical Background
The QSBS exclusion can be used only by noncorporate taxpayers that face numerous corporate- and shareholder-level requirements. The corporate requirements can generally be categorized as: (1) the active business requirement, (2) the qualified small business requirements, and (3) prohibitions on some redemptions of corporate stock. The corporate requirements are further explained below, but we don’t detail the numerous individual requirements.20
First, to meet the active business requirement, a taxpayer must have held stock in a C corporation that meets the active business requirement for “substantially all” of their holding period.21 This means that for any relevant period, at least 80 percent (by value) of the corporation’s assets are used in the active conduct of one or more qualified trades or businesses22 and the corporation is an eligible corporation.23 If the value of specified asset types held by the corporation crosses other thresholds during applicable periods, the active business requirement might not be met during those periods.24
Second, the entity issuing stock must be a domestic subchapter C corporation for U.S. tax purposes at the time of its issuance, and at all times before and immediately after the issuance of stock, the “aggregate gross assets” of the issuing corporation (or any predecessor corporation) must not have exceeded $50 million dollars.25
Third, some redemptions by the issuing corporation of its shares, occurring within specific periods before or after a stock issuance, can cause some or all of the stock issued to fail to be treated as QSBS. Those include two categories of redemptions: (1) redemptions of a taxpayer (or person related to the taxpayer),26 and (2) significant redemptions.27 Despite the detailed corporate requirements, taxpayers have no regulatory guidance on their implementation except as it pertains to redemptions. Further guidance from Treasury and the IRS in these areas would likely be well received.
II. Continued Viability of QSBS
One reason section 1202 was practically ignored during the 1990s and early 2000s was that the unexcluded portion of QSBS gain was subjected to a penalty tax rate of 28 percent.28 That rate was the statutory capital gains rate at the time section 1202 was enacted, which hasn’t been adjusted to follow subsequent capital gains rate changes. Thus, a 50 percent QSBS exclusion on $10 million or less of gain results in an effective tax rate of 14 percent after accounting for the 28 percent rate on the unexcluded portion.29 That doesn’t equal half the current 20 percent capital gains rate (that is, 10 percent). Continued viability of QSBS will require a fix to the QSBS penalty. Policymakers should adjust the tax rate for all QSBS gains to equal any other capital gains (that is, 20 percent). This conformity would help improve equity for U.S. start-ups and continue the viability of QSBS.
III. A New Purpose for QSBS: Restaurants
The restaurant industry was one of the industries hit hardest by the pandemic.30 Why not give QSBS a chance to transform the restaurant industry into an innovative and collaborative industry in the same way many of us view the big names of Silicon Valley? The law now says QSBS can apply only to C corporations that actively conduct a qualified trade or business. A qualified trade or business doesn’t include restaurants.31 This contrasts with policy decisions benefiting small businesses in other areas of the tax code such as the qualified business income deduction under section 199A.32 The legislative history of QSBS provides no background to explain this ineligibility. But in the early 1990s, restaurants weren’t experiencing a historic contraction caused by a pandemic.
QSBS could transform how restaurants are owned in the United States — it’s a known commodity in the tech industry because employees understand that they can join an innovative enterprise and be awarded for their efforts with ownership in the business in a tax-advantaged way. Creative chefs, health enthusiasts, and managers oriented toward customer service should help us all dine together again, and they could have a stake in the business through QSBS. We believe that this type of joint ownership of restaurants could be a welcome and crucial panacea after a bitter pandemic.
a taxpayer is engaged in the trade or business of operating a restaurant or tavern if the taxpayer’s business consists of preparing food and beverages to customer order for immediate on-premises or off-premises consumption. These businesses include, for example, full-service restaurants; limited-service eating places; cafeterias; special food services, such as food service contractors, caterers, and mobile food services; and bars, taverns, and other drinking places.
That’s a great place to start, but what about the “ghost kitchens” that have flooded delivery applications and that suggest a greatly diminished need for “immediate” consumption?
A ghost kitchen is a professional food preparation and cooking facility that makes delivery-only meals. It differs from an actual restaurant in that it is not a restaurant brand and may contain kitchen space and facilities for more than one restaurant brand. Ghost kitchens can work within brick-and-mortar restaurants or function as stand-alone facilities. They helped brick-and-mortar restaurants recoup their losses and minimize employee layoffs by allowing them to prepare food for multiple brands and keep themselves in business. The spike in growth of ghost kitchens is predicted to create a $1 trillion industry by 2030.33
The restaurant industry has been targeted for assistance by other areas of federal legislation outside tax law. The American Rescue Plan Act of 2021, which became law on March 11, 2021, creates a new $28.6 billion grant program — administered by the Small Business Administration — to help restaurants survive the adverse economic effects of the COVID-19 pandemic.34 We know the Biden administration supports hard-hit restaurants and bars.35 We applaud the efforts that led to the Restaurant Revitalization Fund, and we believe that more can be done to ensure long-term success and funding, which is really where QSBS can shine.
IV. Closing Thoughts
Most start-ups don’t last 10 years, let alone five, but changes to section 1202 in the House version of the Build Back Better Act make it less likely that some start-ups will even get the chance to try.36 Start-ups act as kindling to fire up the economy after a recession. We think QSBS burns hot and that Biden understands this.37 Congress is trying to make generational changes with the Build Back Better Act, so why go halfway with QSBS? The government should use this opportunity to build back American start-ups to their full potential through QSBS.
1 The White House, “President Biden Announces the Build Back Better Framework” (Oct. 28, 2021).
2 As discussed further below, section 1202 permits some noncorporate taxpayers to exclude some or all the gain from the sale of specific stock if that stock is also held by the taxpayer for at least five years (and numerous corporate and shareholder requirements are met).
3 See H.R. Rep. 103-111 (1993).
4 When the QSBS incentive was created in section 1202, the House Ways and Means Committee stated that it was intended as “targeted relief for investors who risk their funds in new ventures, small businesses, and specialized small business investment companies, [and] will encourage investments in these enterprises. This should encourage the flow of capital to small businesses, many of which have difficulty attracting equity financing.” H.R. Rep. 103-111, at 831 (1993).
5 Roger Jay Dilger, “SBA Assistance to Small Business Startups: Client Experiences and Program Impact,” Congressional Research Service R44083, at 12 (updated Nov. 24, 2020).
6 In available data from 2018, companies with fewer than 500 employees make up about 46.8 percent of the U.S. workforce. Dilger, “Small Business Administration and Job Creation,” CRS R41523, at 3 (updated June 23, 2021).
7 See American Enterprise Institute for Public Policy Research, “Why the Small Business Administration’s Loan Programs Should Be Abolished,” at 3 (Apr. 13, 2006).
8 According to the Joint Committee on Taxation, the Build Back Better Act’s QSBS changes will cost about $5.7 billion over 10 years. See JCT, “Estimated Budget Effects of the Revenue Provisions of Title XIII — Committee on Ways and Means, of H.R. 5376, the ‘Build Back Better Act,’ as Reported by the Committee on the Budget,” JCX-45-21 (Nov. 4, 2021).
9 Many don’t realize that because of the percentage exclusion, the unexcluded portion of QSBS gain is taxed at 28 percent. That was the maximum statutory capital gains rate back when QSBS was enacted in 1993. Cf. section 1(h)(1)(D) and (4)(A).
10 The National Restaurant Association has gathered crippling statistics: “$659 billion: Restaurant industry sales in 2020, down $240 billion from expected levels; 12.5 million restaurant industry employees at the end of 2020, down 3.1 million from expected levels; and 110,000 restaurant locations that are temporarily or permanently closed.” National Restaurant Association, “National Statistics” (2021).
13 See P.L. 103-66, 107 Stat. 422, section 13113.
14 Sen. Diane Feinstein, D-Calif., stated that section 1202 “will provide patient capital for the startup and expansion of small and midsized businesses. Increasingly, as large businesses downsize, the jobs of the future will come from new businesses and they will be small and midsized businesses.” 139 Cong. Rec. S19729, at S19762 (Aug. 6, 1993).
15 ARRA, P.L. 111-5, div. B, tit. I, section 1241 (Feb. 17, 2009) (temporarily increasing the exclusion percentage to 75 percent).
16 Small Business Jobs Act of 2010, P.L. 111-240, tit. II, section 2011 (Sept. 27, 2010) (temporarily increasing the exclusion percentage to 100 percent); American Taxpayer Relief Act of 2012, P.L. 112-240, tit. III, section 324 (Jan. 2, 2013) (temporarily increasing the exclusion percentage to 100 percent); Tax Increase Prevention Act of 2014, P.L. 113-295, section 136 (Dec. 19, 2014) (temporarily increasing the exclusion percentage to 100 percent), and the Protecting Americans From Tax Hikes Act of 2015, P.L. 114-113, div. Q, tit. I, section 126 of the Consolidated Appropriations Act of 2016 (Dec. 18, 2015) (permanently extending the 100 percent exclusion percentage).
17 The White House, “Remarks by the President and Vice President at Signing of the American Recovery and Reinvestment Act” (Feb. 17, 2009) (Obama stated, “I also want to thank Joe Biden for working behind the scenes from the very start to make this recovery act possible.”).
20 Individual requirements include, but are not limited to, acquiring shares at original issuance, or alternatively through an acceptable conversion, transfer, or exchange. Section 1202(c)(1), (f), and (h). A shareholder cannot also have an offsetting short position against QSBS. Section 1202(j). This is not an exhaustive list. See Janet Andolina and Kelsey Lemaster, “Candy Land or Sorry: Thoughts on Qualified Small Business Stock,” Tax Notes, Jan. 8, 2018, p. 205, for a good discussion of various shareholder QSBS considerations.
21 There is no statutory or regulatory definition of “substantially all” directly applicable to section 1202.
22 The business or businesses conducted by the corporation must each be considered a “qualified trade or business.” No business is specifically identified as a qualified trade or business; instead, the test is exclusionary by identifying several businesses as nonqualified (for example, law, accounting, and consulting). See Paul S. Lee et al., “Qualified Small Business Stock: Quest for Quantum Exclusions,” Tax Notes Federal, July 6, 2020, p. 15, for further discussion of the excluded trade or business categories.
23 An “eligible corporation” is generally a domestic C corporation unless it is taxed under specific categories (e.g., a domestic international sales corporation or former DISC, regulated investment company, real estate investment trust, real estate mortgage investment conduit, or cooperatives).
24 A corporation generally fails the active business requirement for any period in which more than 10 percent of the value of its assets consist of portfolio securities (which aren’t considered subsidiaries) or real estate not used in the active conduct of a qualified trade or business. Section 1202(e)(5) and (7). Also, beginning two years after the corporation is formed, no more than 50 percent of the value of the corporation’s assets can be considered used in the active conduct of a qualified trade or business. Section 1202(e)(6).
25 Section 1202(d).
26 Section 1202(c)(3)(A). Reg. section 1.1202-2 provides de minimis rules.
27 Section 1202(c)(3)(B). Generally, a “significant redemption” equals 5 percent a year before the issuance takes place; however, reg. section 1.1202-2 provides de minimis rules.
28 Section 1(h)(4).
29 AMT can further erode the QSBS benefit because of a preference item that equals 7 percent of the exclusion amount. See section 57(a)(7).
30 In April 2020 U.S. unemployment reached 14.8 percent, the highest peak ever observed by the Bureau of Labor Statistics since it began collecting data. Gene Falk et al., “Unemployment Rates During the COVID-19 Pandemic,” CRS R46544, at 2 (updated Aug. 20, 2021) (see note 10 for 2020 statistics negatively affecting the restaurant industry).
31 See section 1202(e)(3)(E).
32 See Ryan Dobens and Karen Lohnes, “Ins and Outs of Aggregating Qualified Trades or Business — Section 199A,” 72 S. Cal. Inst. on Fed. Tax’n 6-1 (2020).
33 Billy Hamilton, “A Ghost Story: Ghost Kitchens and Their Tax Issues,” Tax Notes State, Oct. 11, 2021, p. 145.
34 See American Rescue Plan Act of 2021, P.L. 117-2, section 5003 (Feb. 24, 2021).
35 White House, “Fact Sheet: The Biden-Harris Administration Supports Hard-Hit Restaurants and Bars” (May 5, 2021).
36 Research has also shown that about 20 percent of all start-ups close in their first year, one-third close within two years, and fewer than half of all start-ups are still in business after five years. Dilger, supra note 5, at 5.
37 The Treasury green book proposals do not include any changes to section 1202 and appear to support the continuation of the “small business stock” exclusion as provided “under current law” in its capital gain proposals.