Two years ago I made a pact with myself that I would read a little bit every night to relax before I go to sleep. I started with magazines, newspapers, executive summaries and pitch decks but found that they were too stimulating to my brain and so it took me too long to fall asleep. I moved to books but after a few all-nighters reading the likes of Unbroken, I course corrected again and cracked open one of the all-time greats: the U.S. Tax Code. Hey, don’t knock it ’til you’ve tried it. In 20 minute spurts, the IRS puts out a great and very useful read.
Only slightly embarrassingly, since my NYU School of Law days when Jerome Kurtz, former Commissioner of the IRS, was my Intro to Tax professor, I’ve always thought our tax laws were interesting — guess it is the most empirical evidence that a great teacher can make even the most seemingly boring subject exciting. Last week, I referred to a few provisions on at least a dozen occasions with people that are very active investors who weren’t aware of some of the amazing incentives designed to help launch businesses, so I figured I’d try to spread the word. If they don’t know about these opportunities, chances are most people don’t.
Let me just throw out the disclaimer that I’m not an attorney nor have I ever been one. With this said, I believe that between now and the end of this year, there’s never been a better time over the past 20 years to start a business — especially in the technology world. There is significant seed capital available from Angels and super-Angels, terms are very entrepreneur-friendly, technology build costs are extremely low, hundreds of industries are in the midst of major disruption (check out media, music, directories/networks, gaming et al for a few examples). People are avoiding offline businesses (see above — great for you contrarians). And, if you don’t have an “original” idea, no problem. Recognize that world class execution of an existing idea is incredibly innovative in and of itself — unless of course you believe that Apple invented computing, Facebook invented social networks or Google invented search.
But all of these characteristics don’t have an immediate time frame so why did I cap the period at December 31, 2011? Because of the Small Business Jobs Act (and related legislation) — dim the lights, put on the music and pan back to my comments about my light, night reading.
Historically, if one were to invest in a “Qualified Small Business” (defined roughly as any business that isn’t a real estate or investment firm that has less than $50 million of gross assets that actually tries to make something or build a product/ service — or, just watch “Say Anything” and listen to Lloyd Dobler describe his career goals as he pretty much nails it), and the stock of that QSB were held for 5 years, then the stockholder would have 50% of any capital gains realized upon the sale of that stock excluded as income. In other words (and there’s a clear example far below if you get lost along the way), 50% of your gain (up to $10m of gain per taxpayer) would be excluded from taxation under capital gains guidelines (practically, the way this works is that 50% of the gain is excluded from taxes (i.e., 0% tax rate) and the other 50% is taxed at the AMT rate of 28%, so, effectively, you’re only saving 1% (15% versus 50% x 28%). However, most states follow the federal taxable income guidelines and, since there is no AMT at the state level, you halve your state taxes (same for local)). But, wait for it, wait for it — and if you’ve followed me up to this point, congratulations — it gets even better, way better.
The Small Business Jobs Act, as a way of encouraging investment in small businesses, changes that 50% exclusion to a 100% exclusion. In other words, if someone invests in a QSB between now (actually it was, if I recall correctly, September 2010) and the end of THIS year AND holds that stock for 5 years and sells it, any gain is TAX FREE (up to $10m but, at that level, let your accountant worry about it while you’re on your boat off the coast of Monaco.)
I shared this information with a good friend and he and his wife treated me and my wife to Per Se after his accountant verified he was going to save a substantial amount of money — that tends to be my customary rate (dinner or show me your most interesting investment opportunities).
Now, let’s say that you start a company (or make that Angel investment) and some strategic feels that your business is a must have in 15 months (not quite that 5 year holding period) — not to worry. You can actually also defer any capital gain on the sale of stock in a QSB so long as you take the proceeds and reinvest them in another QSB. This has always been the case under Section 1045 (similar to a 1231 like kind exchange in real estate).
As a series of quick examples, let’s assume you sell a QSB for a capital gain of $10m. Without Section 1202 (which is how most people who don’t know about how these provisions work file their taxes), assuming the 5 year hold, your Federal capital gains tax would be $10m (your gain) x 15% (Fed cap gains rate) or $1.5m and your state tax would be 5% (assuming you live in Connecticut, like I do) or $500k for a total capital gains tax of $2m.
With Section 1202 but pre-SBJA, you would take your $10m gain x 50% x 28% (AMT rate) for a Federal tax of $1.4m ($100k of savings). And, your state rate would be 5%, BUT on only $5m (i.e., only 50% of the $10m). So, thanks to Section 1202, you’ve just seeded your next business or saved $350k ($100k in Federal taxes and $250k in state taxes), depending upon how you look at it. However, under the CURRENT law, post-SBJA (which, again, expires at the end of this year), you would take your $10m gain and would exclude ALL of it at the Federal level. And, in CT, at the state level too. So, instead of $2m in capital gains taxes, you’d pay $0 in capital gains taxes.
The biggest takeaway from this information is to get off of that fence and start (or invest in) a business. Talk with an accountant or attorney that knows about provisions like these. It’s hard enough to start, scale and exit a business such that earning an extra 20%+ isn’t something to take lightly. Without getting into too much tax policy discussion, I think our entire Code should be overhauled with an eye on making it equitable and supportive of people who work hard and/or create jobs in this country. And, in my opinion, there is a very big difference between buying primary stock and secondary stock and our tax provisions should reflect the distinction.