Venture Capital Group Seeks to Encourage New Company Growth
DATED SEP. 13, 2017
Tax Analysts is publishing this document, with a missing page or pages, in the form in which it was received from Treasury's Office of Tax Policy.]
PROPOSALS TO ENCOURAGE NEW COMPANY FORMATION
RESEARCH AND DEVELOPMENT TAX CREDIT
PROPOSAL: Expand ability of startups to offset payroll taxes with accumulated R&D credits. Specifically, NVCA proposes that startups with less than $100 million in assets (QSBS eligibility threshold with proposed NVCA modification) be able to offset up to $1 million worth of payroll taxes with R&D credits.
CURRENT LAW: Current law allows very early stage startups, less than five years old and with less than $5 million in annual sales, to use R&D credits to offset up to $250,000 in payroll tax obligations.
REASON FOR CHANGE: Congress made a great start in encouraging the growth of more innovative American companies when this provision was created recently as part of the PATH Act. But the size restrictions associated with the provision leave many startups unable to access the benefits of their R&D credits. A typical startup will still be quite early in the process of development when the size/age limits eliminate their ability to benefit from the R&D credit. This creates a strange dichotomy where startup companies cannot access the benefits of the R&D credit when they need it the most.
As global competition for innovative entrepreneurship continues to increase, a number of other countries including Canada, Spain, France and Britain, have created variations of refundable R&D credits. We believe that these improvements to the R&D credit will provide a fair and material benefit for American startups and will be a strong step forward in shoring up our leadership in entrepreneurship.
4. Tie eligibility of all company stock to same reporting metrics by the company so that a QSB is only a company that satisfies the annual reporting requirements on a newly established QSB form (see number 3), similar to REIT declarations.
5. Reduce the prohibited period for redemptions from 4 years to 2 years
a. This would help with documentation complications that startups often have.
6. Clarify that the active business requirement not disqualify certain active businesses such as healthcare services.
Reforms to Expand 1202
7. Increase $50 million dollar threshold to $100 million.
8. Index asset threshold to inflation.
Section 1045 Rollovers
9. Expand rollover period to 180 days.
10. Allow rollovers at firm level to be eligible.
CURRENT LAW: Section 1202 was originally passed with strong bipartisan support to further the goal of driving American job creation, innovation and long-term economic competitiveness by providing a benefit to investors who provide long-term capital investment to innovative small businesses. Current law allows investors in certain startups with less than $50 million in assets who hold the stock for at least five years to exempt up to $10 million or 10 times the basis of the stock, whichever is greater, from capital gains taxes.
REASON FOR CHANGE: The Qualified Small Business Stock (QSBS) rules contained in Section 1202 can be an effective motivation for investments in early stage startups. Unfortunately, the significant complexity of the eligibility rules and a size limit that hasn’t increased with inflation or economic realities have limited the ability of Section 1202 to bolster the entrepreneurial ecosystem as well as the policy goals envisioned by those who passed the law. We propose a number of ideas to make it easier to determine the eligibility of investments while keeping in place the anti-abuse rules currently in the law. We also propose several ideas to expand the impact of 1202, to update its size limits and to increase its potential for driving investment into startup communities across the country.
Of particular importance, if Congress makes the recommended reforms. Section 1202 could become one of the most powerful incentives for venture capital fund and entrepreneurial capital formation in non-coastal regions, places where large institutional (and tax-exempt) investors do not often invest in venture capital. A more predictable investment incentive can increase the number of angel capital investors and encourage more investors into regional venture capital funds, both critical elements to growing more startup communities around the country.
As stated above, if one excludes California, Massachusetts, and New York, the median size venture capital fund in the U.S. is about $15 million dollars. This is simply not big enough for most large institutional investors, so attracting taxable investors is critical to expanding entrepreneurship to more regions in the country. Making 1202 easier to understand is a powerful way to encourage that expansion.
SECTION 382/SECTION 383 SAFE HARBOR
PROPOSAL: Create a safe harbor from Section 382/Section 383 limitation rules for startups going through viable fundraising rounds and ownership changes.
NVCA has worked on the following safe harbor proposal that would apply to companies less than 12 years old:
Exempt capital contributions to the company from ownership change calculations. In other words, capital contributed to the company from a fundraising round would be disregarded for purposes of determining an ownership change under Section 382/383.
Exempt R&D expenses (defined as Section 174 expenses) from limitation, protecting these expenses, which generally receive favorable tax treatment, from loss limitation penalties.
Provide a more robust long-term tax exempt rate for all other accumulated Net Operating Losses (NOLs) by allowing an additional 5 percentage points to be added to the rate (currently around 2%).
In broad strokes, the current limitation is determined by multiplying the fail-market value of the company by the long-term tax exempt rate. This equation creates the ceiling for the amount of NOLs that can offset income per year going forward. The lower the long-term rate, the more severe the limitation will be.
For instance, a company that sells at a $50M valuation could see their allowance triple from an annual limitation of $1.25M to $.375M.
Exempt R&D credits from limitations under Section 383.
The special rules for qualified new loss corporations would not apply to loss corporations who do not comply with the continuity of business enterprise test under subsection (c)(1), disregarding (c)(2).
CURRENT LAW: Section 382/383 drastically limits, and very often eliminates the ability of startups to utilize accumulated NOLs and R&D credits as they raise investment capital and grow their businesses. The basic model of entrepreneurship necessarily generates NOLs that should be available to offset income if the company becomes profitable. But the Section 382/383 rules often impose an overly restrictive limitation on most startups, thereby creating an arbitrary penalty for investment in hiring and innovation.
REASON FOR CHANGE: In an attempt to combat loss trafficking. Congress created a complex tax regulatory regime that specifically targets loss corporations going through ownership changes. Unfortunately, the law does not take into account the fact that most startups are loss corporations as they spend their formative years either in a loss position or completely prerevenue while they take investment capital to build out their businesses. It’s important to remember that, despite the fact that the rules were intended to combat abusive transactions where companies were being acquired solely for their losses, the current reality is that Section 382/383 impact a broad swath of viable startup transactions for no legitimate public policy purpose.
Under the statute, an IPO, merger or acquisition, or even a fundraising round can constitute an ownership change and trigger penalties under Section 382/383. Even worse, many startups simply surrender the value of their NOLs and R&D credits in the face of the incredible complexity of the rules. This has the economic effect of increasing the cost of R&D investment at the startup level, a dangerous and counterproductive policy consequence of these overreaching tax regulations.
Congress can foster economic growth simply by modernizing the rules in the code to stop penalizing startups for investing in job creation and innovation Startups are seeking solutions to some of the most challenging issues we face, including cures for cancer and other diseases, technological innovation, cyber security and energy. Importantly, because startups generally spend most of their capital on R&D and salaries, the types of expenses these rules limit for startups are some of the most societally beneficial expenditures with the greatest economic and human impact. In other words, the Section 382/383 rules actually punish startups for incurring the same expenses that, for incumbent companies, federal policy seeks to encourage.
EMPOWERING EMPLOYEES THROUGH STOCK OWNERSHIP ACT
PROPOSAL: Pass the Empowering Employees through Stock Ownership Act, which would allow startup employees to defer tax liability on income arising from exercised but illiquid stock options.
CURRENT LAW: Generally, employees must pay tax when they exercise their options or when their Restricted Stock Units (RSUs) vest.
REASON FOR CHANGE: Stock options are a critical tool for attracting talented individuals to work at our nation’s startups. Employees are often compensated with stock options as a promise that if the startup succeeds, everybody shares in the gain. Stock options are particularly important for startups that are often cash strapped and using all resources available to develop and build a novel product. But as the U.S. capital markets have become more hostile to small capitalization companies, many startups are opting to stay private longer rather than pursue an initial public offering (IPO). This has given rise to challenges for employees at our nation’s startups when their stock options vest without a liquid market to sell their shares in order to pay the taxes that are due.
Allowing an additional period of time for employees to defer taxes on exercised stock options is a common sense solution to this challenge that will encourage more talented Americans to help build today’s startups into tomorrow’s Fortune 500 success stories.
TAX POLICY FUNDAMENTAL TO THE ECONOMICS OF THE ENTREPRENEURIAL ECOSYSTEM
CARRIED INTEREST CAPITAL GAINS
CURRENT LAW: Carried interest has historically been eligible for capital gains treatment because it is the venture capitalist’s share of the profits from a partnership that builds startups over the long-term. These profits are a result of years of value creation from an initial risky investment and a great deal of hard work from everyone involved. It is important to remember that successful venture capitalists do not simply pick winning investments; they build winners by providing value to a startup throughout the company-building lifecycle over a long period of time. They often support portfolio companies with multiple investment rounds generally spanning five to ten years, or longer, serve on the boards of portfolio companies, provide strategic advice, open contact lists, and generally do whatever needs to be done for a company to succeed.
Carried interest capital gains are similar to stock awards received by startup founders in that both venture capitalists and founders invest time, energy and creativity against huge risks in the hopes of creating long-term value. As a result, both types of ownership interests are currently eligible for capital gains tax treatment if they succeed.
RATIONALE FOR CURRENT POLICY: While many different factors have converged over time to create America’s leadership in innovation, significant credit is due to our long-standing tax policy that supports the spirit of entrepreneurship. One such policy is the capital gains treatment of carried interest received by venture capitalists.
Role of Carried Interest Capital Gains in Venture Capital
Carried interest is the primary economic incentive for participation in venture capital. Venture capitalists create partnerships with institutional investors to combine the capital held by pension funds, endowments, foundations and others with their talent and expertise (and their own capital) to make risky, long-term equity investments into innovative startups. These are generally partnerships that last ten to fifteen years. Carried interest is the general partner’s share of gains (if there are any) from the partnership in accordance with the partnership agreement. Capital gains treatment of carried interest is an important feature of the tax code that properly aligns the long-term interests of investors and entrepreneurs to build great companies together since the creation of the modern venture capital industry. Venture capital activity is entirely consistent with the core concepts of a log-term capital gains tax rate. As such, partnership gains attributable to the general partners of a venture capital partnership should continue to be afforded capital gains treatment.
Benefits of Current Policy:
If one were ’white boarding’ the best public policy solutions to encourage new company creation, they would be hard pressed to find a more perfect alignment of interests than the carried interest capital gains a venture capitalist receives from a successful startup investment. When a startup fails, the carried interest on a deal is zero. In fact, canted interest is only realized if one or more startups in a venture capital fund are so successful as to offset the inevitable failures in the fund. Carried interest tax policy is defined by a simple equation, which holds that no benefit is extended unless and until our country receives the benefit of greater economic activity through company and job creation. This policy has been critical to our country’s economic success.
Venture Capital would be Most Severely Impacted Industry
Despite the significant amount of public discussion about earned interest capital gains being a tax benefit for hedge funds, a tax increase on earned interest capital gains would have the least impact on the hedge fund business model and the most severe impact on the venture capital business model. Reasons for this include:
Venture capital is the smallest asset class of investment partnerships. To put this in perspective, the asset size of the two largest hedge funds adds up to the size of the entire venture capital industry. Management fees are a far less significant source of compensation for VCs, meaning the potential for carried interest is far more critical, and in fact is the primary economic incentive for participation in venture capital.
Venture capitalists hold assets for the longest, and therefore wait the longest to realize carried interest if their fund is successful. As stated above, the typical VC partnership agreement runs a decade, with options for extensions for further years that are commonly exercised, hi the time it takes a VC to realize carry from one fund, participants in shorter-term asset classes can see carry from multiple funds. Conversely, a significant amount of hedge fund assets are not even held long enough to qualify for the long-term capital gains rate.
Venture capital is also among the highest risk asset classes, with a majority of venture capital funds never seeing carried interest.
Consequences of a Carried Interest Capital Gains Tax Increase:
A tax increase on carried interest capital gains actually runs counter to urgings by many economists and policymakers on both sides of the aisle who maintain that patient, equity investment be rewarded over short-term bets and financial engineering. The net result of a tax increase on carried interest capital gains would be a shift away from riskier investments with greater promise for breakthrough innovation and towards safer investment strategies that favor incremental progress.
In addition, a tax increase on carried interest earned by venture capitalists would have its most severe impact on new fund formation, particularly in underserved regions of the country. Setting aside California, Massachusetts, and New York, the median size venture capital fund in the remaining 47 states is about $15 million. The 2 percent management fee on a fund of that size means that, after fund expenses, there might be little or nothing remaining for general partner salaries. In these cases, carried interest capital gains can be the sole economic incentive for participation in venture capital.
Sadly, in this increasingly global competition to build the next generation of companies, the current debate over carried interest capital gains has it all wrong. In fact, if there are changes to the taxation of the entrepreneurial business model, they should be to instead support participation in the entrepreneurial ecosystem to shore up our leadership position.
CAPITAL GAINS RATE DIFFERENTIAL
CURRENT LAW: America has benefited from significant risk investment and entrepreneurship encouraged by maintaining a globally competitive capital gains rate with a meaningful differential between the capital gains tax rate and ordinary income rates.
RATIONALE FOR CURRENT POLICY: U.S. capital gains tax policy has been critical to the success of the U.S. entrepreneurial ecosystem. Primarily, the policy has facilitated patient capital formation for high-risk enterprises and encouraged entrepreneurship.
The Role of Capital Gains Policy in Facilitating Patient Capital Formation for Startups
A competitive capital gains tax rate with a meaningful differential from the top ordinary income tax rate is fundamental to fostering a climate where entrepreneurship and risk investment can continue to flourish. The business model of venture capital is to invest for longer periods (5-10 years on average) in risky companies with little track record but strong growth potential. The long-term and high-risk nature of venture capital make it particularly sensitive to investment policy. A basic rule of finance is that the longer capital is invested without a return to the investor, the higher the return must be to compensate for that illiquidity. Venture capital activity is exactly in line with the philosophy behind a capital gains rate differential. In fact, an additional lower rate for longer-held investments in startups, such as that offered by the Qualified Small Business Stock Rules (QSBS), is an improvement to our investment climate because of the significant holding periods that are the norm for entrepreneurial investment.
Angel and venture capital are the only significant sources of patient capital available to startups and entrepreneurs. America is the global leader in innovation — a critical component in a globally competitive economy — in large part because of our entrepreneurial capital formation climate.
And as we can see from the economies of other countries, if venture capital isn’t around to support an entrepreneurial ecosystem, no other investment class, nor government spending, can fill this gap.
The Role of Capital Gains Policy in Encouraging Entrepreneurship
The capital gains rate is also critical to encouraging Americans to become founders of companies. Whether to undertake the challenge of entrepreneurship is an incredibly difficult decision. As a society, we hope these men and women will leave their jobs and dedicate their lives to an endeavor. But they must make this choice knowing that it is more likely than not to fail, potentially leaving them without an income or benefits, and an uncertain future.
Much of the success of a country’s entrepreneurial ecosystem is determined by an appetite for risk, which is largely a combination of the policy environment and cultural norms. It must be acceptable both financially and culturally to try and fail. And the rewards for success must be significant enough to make taking such huge risks worthwhile, particularly in light of the high failure rates of startup-up companies. A competitive capital gains rate with a meaningful differential is a core policy choice that facilitates this environment.