How VCs can avoid capital gains increase impact

VCs can take advantage of two provisions in the tax code to stave off the potential impact of higher capital gains and carried interest tax, says accounting firm EisnerAmper.

As the US government continues to debate possible tax hikes, the venture world is bracing for its effects. However, venture capital, especially smaller funds, can still take advantage of two provisions that encourage investment into new companies.

Under president Biden’s Build Back Better plan, the capital gains tax rate could increase from 20 percent to 39.6 percent for Americans earning more than $1 million. In addition, it could essentially close the carried interest loophole, which venture capital firms have long used.

Kayla Konovitch, a partner at the financial services group at the accounting firm EisnerAmper, said certain provisions of the tax code benefit the venture business model even if taxes are increased. One of these is section 1202, also known as the Small Business Stock Gains Exclusion.

“What the Code says is that if you’re a venture capitalist that invests in a qualified small business, such as technology or software, which are very common investments for VCs, you could exclude up to 100 percent of your gain,” Konovitch said. “The idea is that Congress wants to incentivize people to help small businesses raise capital.”

Konovitch noted that section 1202 allows investors who hold the small business stock for five years to claim exclusions from capital gains.

“[The provision] is usually a slam dunk for early-stage investing like pre-seed, seed and through to Series B because almost every one of their transactions would qualify,” said Konovitch, who is based in New Jersey. “In terms of later-stage venture capital, it’s also possible to meet the criteria. When you’re investing in late-stage VC, the bigger question is: are you going to be holding that stock for at least five years?”

Another provision, section 1045, also allows investors to save on taxes if they sell stock they held for six months if they reinvested gains from the sale to another qualified business within 60 days.

The potential changes to the tax rate sent the venture capital world reeling with concern about the impact of increases in capital gains and carried interest. Additional legislation proposed by senators Amy Klobuchar, Democrat of Minnesota, and Josh Hawley, Republican from Missouri, could make it difficult for companies to make acquisitions. VCs believe caps on mergers limit entrepreneurship.

Congress is still debating a possible change to capital gains taxes, Bloomberg reported. Treasury secretary Janet Yellen told a Senate panel on June 16 that any increases will not be retroactive. If approved, it will be the largest overhaul in investment taxes in recent history.

Konovitch said investors would likely be more wary when making investments even if section 1202 and 1045 are not repealed.

“People are going to be much more cautious in selecting investments, as they understand if tax rates increase, it affects their returns,” she said. “There will be a lot more competition around getting into certain investments and deals. There’s going to be less opportunity for investors too if everyone’s targeting the same opportunities, which is good for the start-ups, but it’s not as great for investors.”

The National Venture Capital Association has already lodged its opposition to the proposed tax increases and possible anti-trust laws.

Correction: A previous version of this story misidentified EisnerAmper. It is an accounting firm.