The best tax loopholes hide in plain sight.
While the recent fiscal negotiations focused mostly on changes to the top income rate, the final bill (H.R. 8) contains a bonanza—52, to be exact—of what are known as “tax extenders.” The tax extenders are temporary or permanent extensions of special tax relief for particular industries or types of investments.
Congress likes these tax extenders, which have come to dominate the tax legislative process in recent years. The temporary nature of extenders reduces their estimated costs; budget estimates assume that the provisions will sunset as promised, instead of being extended each year, as most in fact are.
In addition to finessing the budget process, the annual ritual of enacting the tax extenders gives Congress a regular opportunity to check in on favored industries to see if they have been naughty or nice. As public scrutiny has led to a decline of direct spending in the form of earmarks, indirect spending through tax expenditures has become a more comfortable method of extracting campaign donations from industry and doling out tax breaks in return.
The worst tax extenders have gotten some unwanted media attention. These include the special expensing rules for film and television productions, Nascar venues and rum production, and creative tax breaks for both fossil fuels and clean energy. But even the less offensive tax extenders, which tend to slip under the radar, are questionable from a tax policy perspective.
Consider the special provision for “qualified small business stock,” which provides a zero percent tax rate on capital gains from certain investments. A better name would be the “angel investor loophole.”
The tax break mainly benefits angel investors, who are individuals (often retired entrepreneurs) who invest in early stage companies. As these start-ups grow, they seek funding by venture capitalists, eventually seeking to be acquired or sell stock to the public. (Venture capitalists have held on to their own special tax break for carried interest.)
The special rules for qualified small business stock were first enacted back in 1993. The rules offered a 50 percent exclusion from the then-applicable 28 percent rate for capital gains, creating an effective 14 percent rate.
But as the base rate on capital gains dropped down during the last decade to 20 percent and then to 15 percent, the 14 percent rate for qualified small business stock became trivial. Then in 2009, the American Recovery and Reinvestment Act knocked the special rate for qualified small business stock down to 7 percent. That was followed up in 2010 by a bill taking the special rate down to zero.
The rules work as follows: If you invest in a qualified small business, and hold the investment for at least five years, then your tax rate on any capital gains is zero. The amount of income excluded from tax is limited to the greater of $ 10 million, or 10 times the original cost basis of the investment. So a founder of a company who contributes only labor can avoid paying tax on the first $ 10 million of profit; an angel investor who put in $ 2 million can avoid paying tax on the first $ 20 million.
Why haven’t you heard of this rule? The rules are tailored to apply only to investments in certain types of small businesses. To qualify, the business must be organized as a C corporation. Most small businesses, by contrast, are organized as pass-throughs (partnerships, L.L.C.’s, or S Corporations), which allows them to avoid corporate-level taxes. The main group of small businesses that organize as C corporations are those that expect to seek venture capital or other institutional funding.
Of course, angel investors and venture capitalists argue that these are precisely the type of start-ups that tend to create new jobs, and thus they should be encouraged, not taxed. Perhaps the low tax rate encourages angels to put more money into start-ups instead of index funds. Maybe an engineer quits her job and starts a company knowing the first $ 10 million is tax-free.
On the other hand, it’s not clear that the tax break is necessary to encourage investment that would not otherwise take place. Angel investing fluctuates according to expectations about whether certain markets—dot-coms in the 1990s, social media start-ups in the 2000s, mobile computing today—will stay hot long enough to give the investors a lucrative exit. Tax is not a first-order consideration.
If there’s any doubt that this special tax break is about handouts, not job creation, it’s resolved by looking at the details of the bill. The legislation offers the zero percent tax rate retroactively for 2012 investments, as well as new investments going forward. It’s hard to see how a tax break provides incentives for investments that were either made, or not, last year.
Obviously, the angel investor tax break isn’t the worst thing in the tax code. It’s projected to cost us about $ 1 billion in revenue, assuming it isn’t renewed. But even the most appealing tax break erodes the tax base, requiring higher rates on the rest of us to make up the difference in revenue.
For further reading on the tax treatment of investments in start-ups, see Victor Fleischer, “Taxing Founder Stock,” UCLA Law Review (2011). For further reading on angel investing, see Darian Ibrahim, “Financing the Next Silicon Valley,” Washington University Law Review (2010).
Victor Fleischer is a professor at the University of Colorado Law School, where he teaches partnership tax, tax policy and deals. Twitter: @vicfleischer