The prospect of earning millions of dollars would, at first blush, seem like reason enough to want to start a successful company. Yet Congress has for years sweetened the deal, offering start-up founders and early investors the added incentive of making much of their money completely tax-free.
Tucked into the huge set of tax cuts that Republicans passed into law this month was an expansion of the unusually valuable tax break. The generosity of the change came as a surprise to even some in Silicon Valley, where the tax measure is popular.
“Everyone was like: ‘Are you joking?’” Christopher Karachale, a San Francisco lawyer who helps people claim the tax break, said. “These founders and early employees, they’re already getting a huge benefit. So if anything people are thinking: ‘Wow it’s remarkable the statute got opened up all this more.’”
The tax break, known as the qualified small business stock exclusion, is a decades-old element of the tax code that Congress has repeatedly made more generous. It allows investors and founders to skip out on paying taxes when they cash out their shares in start-ups. For early owners of stock in a business that started as a shoestring operation and became a major publicly-traded company, like Lyft or LinkedIn, or was bought out by another firm, that could mean millions in tax savings.
After warding off an attempt by Democrats to narrow the tax break under former President Joseph R. Biden Jr., trade groups representing venture capitalists saw an opportunity to hitch their own tax cut to the broader G.O.P. effort.
“Every once in a while you get lucky,” said Bobby Franklin, the chief executive of the National Venture Capital Association who has been pitching lawmakers on expanding the tax break for years. “And somebody that it resonates with is in a position to advocate for its inclusion at the right place, at the right time.”
Before the latest change, people who had a stake in a company when it had less than $50 million in gross assets — a group that could include the founders, early employees and early investors — did not owe taxes on the first $10 million they earned from selling their stock. To qualify, investors had to hold the stock for at least five years, and the company could not be focused on providing services like accounting or banking.
Now, after the recent changes, initial investments in larger companies — those with $75 million in gross assets — can receive the special tax treatment. And the tax exemption will start to ramp up earlier. People who hold the stock for three years will able to cut their tax bill in half, with an additional discount after four years, instead of having to wait the full five years to sell tax-free.
At that point, up to $15 million in gains, rather than $10 million, won’t be hit with the top capital-gains tax rate of 23.8 percent. (The new limits will climb over time with inflation). And the tax savings can be multiplied by depositing stocks in trusts, a practice called “stacking” that has become popular with those in Silicon Valley who hit it big.
The tax break overwhelmingly benefits the richest Americans. A study released this year by a team of Treasury Department tax economists found that people making more than $1 million a year had netted more than 70 percent of all the tax-free dollars claimed through the tax break between 2012 and 2022. Critics have blasted the provision as a wasteful giveaway to people who were already motivated to start or invest in a business that could make them extraordinarily wealthy.
“It’s everybody’s worst picture of the tax code,” said Victor Fleischer, a tax law professor at the University of California, Irvine. “This little loophole that people have created and exploited by the very richest people with the very best advisers and, meanwhile, we’re supposed to have this big tax bill that’s delivering for the little people.”
The larger tax exemption is one of several elements of the Republican law that will benefit business owners and investors, generally a wealthy crowd. Another is a 20 percent deduction for owners of businesses who pay individual, rather than corporate, taxes on their firms’ profits, a common arrangement. Previously temporary, that deduction is now permanent, as is a tax reward for investing in low-income areas listed as “opportunity zones.”
To investors, and the lawyers that advise them, the tax exemption for successful investments in start-ups is necessary to support America’s technology industry. Without the added tax incentive, not as many people would choose to start or invest in a new company, leaving the economy less dynamic, they say. Some academic economists have found that the tax break led to more investment in and the creation of new companies.
Pat Gouhin, the chief executive of the Angel Capital Association, said he represents investors that are generally retirees and former entrepreneurs who invest $10,000 to $20,000 at a time in small companies in their communities. The new ability to cash out investments after only three years and still receive a tax break, he said, would prove particularly beneficial.
“It allows for a recycling and churning of that money more quickly,” he said. “It will keep more capital in the game.”
The tax break is most valuable for big-time investors, including partners in venture capital funds and private equity firms. That’s because people can exempt up to $15 million from taxes or ten times the value of the investment they put into the company, a potentially much higher limit. Someone who invested $10 million, for example, could cash out up to $100 million completely tax-free. Allowing investments in companies with $75 million in assets will only create more opportunities for supersized, tax-exempt investments, lawyers said.
Such sophisticated investors, hoping to milk every extra dollar out of their bets, are well-schooled in the details of the tax break. The people who actually start the companies, though, are sometimes unaware of the tax incentive Congress has created for them to innovate.
“It’s a very happy surprise for some people,” said Justin Miller, the national director of wealth planning at Evercore Wealth Management. “In the Silicon Valley tech industry, there’s a lot more familiarity with this exclusion, but it applies way beyond the tech industry.”
Democrats had tried to curb the measure, including new limits in legislation that passed the House in 2021, but ultimately died in the Senate. The failed effort helped spawn a new lobbying push to preserve the tax break, a defensive move that soon morphed into an offensive one.
Several think tanks and trade groups, including the Angel Capital Association and the National Venture Capital Association, banded together to form the Innovator Alliance, which then pushed to expand the measure. They worked with two lawmakers, Representative David Kustoff, Republican of Tennessee, and Senator John Cornyn, Republican of Texas, who introduced legislation in 2023 that mirrored many of the changes that recently became law.
The joint group also sought to defend the carried-interest loophole, which gives partners in venture capital and private equity firms a lower tax rate on their income. President Trump had said he wanted to close the carried-interest loophole this year.
On both fronts, the lobbying effort was successful; Republicans preserved the carried-interest measure despite Mr. Trump’s desire to close it, and, though it wasn’t included in the House version of the bill, the expansion of the lavish break for start-up founders and investors ultimately became law.
At a cost of roughly $17 billion over ten years, the changes to the investment incentive are just a small piece of the $4.5 trillion in overall tax cuts included in the legislation. But the $17 billion cost still puts it at more than half the roughly $32 billion cost of the Republican plan for “no tax on tips,” one of Mr. Trump’s signature campaign promises.
“It’s a very nice win,” said Mr. Franklin, the leader of the venture capital association. “And it’s a nice win because it continues to recognize that tax policy should encourage long term capital formation and should help to form capital for entrepreneurs and early stage start-ups.”
Andrew Duehren covers tax policy for The Times from Washington.
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