In the Midst of Tax Cut Debate, QSBS Capital Gains Tax Fix is Within Reach –

The buzz this spring in Washington has centered on the Administration’s ambitious $1.6 trillion tax cut proposal. As promised during last fall’s campaign, the President’s plan focuses heavily on the personal income side of the ledger. The White House has made it clear that they intend to concentrate on three core objectives in this all-important first effort at tax relief: an across-the-board cut in the personal income tax rate; elimination of the so-called “marriage penalty”; and estate tax repeal. Passage of this initial package, the Administration argues, will build the political capital needed to move forward on other forms of tax relief – including capital gains.

Rather than wait – to paraphrase a baseball term – for a tax cut to be named later, our industry representative in Washington, the National Venture Capital Association (NVCA), is now seeking to secure the preferential capital gains tax treatment that was promised in previous reforms but has not fully materialized due to subsequent changes to tax law. The changes the NVCA is seeking would restore incentives to invest in “qualified small business stock” (QSBS). These incentives were originally put in place by Congress some time ago. Subsequent congressional activity and a lack of guidance from the Treasury Department have largely invalidated these incentives.

Several years ago, Congress enacted section 1202 of the Internal Revenue Code, which was designed to encourage investment in qualified small business stock by imposing a lower capital gains tax rate on dispositions of such stock held for more than five years. Section 1202 is a narrowly targeted provision, imposing many requirements that must be satisfied if stock is to be treated as QSBS. If these requirements can be met, Section 1202 provides for a 14% capital gains rate for “regular tax” purposes for up to $10 million in gains per issuer.

When Congress enacted the section, it also added IRC section 57(a)(7), which treated one-half of the section 1202 reduction in regular tax as an item of tax preference for alternative minimum tax (AMT) purposes. As a result, taxpayers subject to AMT at the maximum rate who sold QSBS effectively could realize a seven percentage point reduction (to 21% from the 28% maximum “regular” rate at the time), equivalent to a 25% reduction in gains rates.

In 1997, Congress lowered the overall capital gains rate to 20%. At the same time, it also provided that gains eligible for special treatment under section 1202 did not qualify for the 20% rate, and amended section 57(a)(7) to reduce the percentage of capital gains excluded under section 1202 that would be treated as a tax preference item from 50% to 42%. As a result, taxpayers subject to AMT at the maximum rate who sold QSBS effectively could realize only a 0.12 percentage point reduction (to 19.88% from the 20% “regular” rate), equivalent to only a 0.60% reduction in gains rates.

In order to restore the incentive to invest in qualified small businesses, the NVCA is working with key policy makers in Congress to fix this unintended and counterproductive situation. Last month, legislation was introduced by Sen. Susan Collins (R-Maine) to strike section 57(a)(7), increase the exclusion of gains from QSBS from 50% to 75%, reduce the holding period from five years to three years, and to make other beneficial changes. By providing for a significant capital gains rate differential – and providing it for all taxpayers – the Collins legislation (S. 455) would be an enormous step in the right direction and the NVCA has made its passage a priority.

Still other bureaucratic impediments exist to the realization of Congress’ intention of ensuring preferential tax treatment on QSBS capital gains. IRC section 1045 allows taxpayers other than corporations that sell QSBS held more than six months to defer tax on gains if they invest the proceeds in other QSBS within 60 days of the sale. Problems arise, however, due to the fact that section 1045 is silent (and the Treasury Department has issued no guidance) regarding how venture capital partners can obtain rollover benefits in the context of a variety of very common transactions. For instance, no guidance is available on how partners can obtain rollover benefits if the managing partners are entitled to a carried interest in partnership profits that is disproportionate to their capital contributions. Another example is the lack of guidance on how a partner’s share of gains from a QSBS sale can be rolled over if another partnership to which that partner has contributed capital makes a timely investment in an other QSBS.

To restore Congress’ original intent, the NVCA is working with members of the House and Senate who are urging the Treasury Department to issue regulations under section 1045 to provide the necessary guidance. In lieu of a regulatory fix, the NVCA and its congressional allies may seek legislation to assure the intended rollover benefits.

In light of a down market and a slowing economy, the timing of the Collins legislation and the activity addressing the QSBS rollover provisions could not be better. At the same time that the Bush tax cut proposal moves forward, advancing these measures will assure that the entrepreneurial community – the catalyst to our economy’s remarkable growth in the last decade – will be provided with the necessary capital to continue its important work. t

Steven Lazarus is Founder and Managing Director of ARCH Venture Partners which has offices in Chicago, Austin, Seattle, Albuquerque, and New York. He is Chairman of the NVCA Research Committee.