If you haven’t subscribed yet, you can get thoughts and musings about personal finance and whatever else I find interesting straight to your inbox by clicking here:
If you haven’t been keeping up with the news, Biden’s infrastructure bill has been slowly progressing (or not) through the legislative system. The contents of the actual infrastructure bill is pretty well understood at this point, but Congress is using reconciliation to split apart the spending portion from the “how we pay for it” portion. Some of the details of how Congress would like to pay for the spending are starting to come out, and specifically, the House Ways and Means Committee released a document detailing some of those revenue-generation tactics (a big thank you to my very on-top-of-things partner, who actually saw this before I did). I wouldn’t call this light reading, but there are definitely some interesting sections, relevant to my interests, which means you, the reader, get to go on a journey with me.
Changes to Qualified Small Business Stock
If you read my newsletter regularly, you likely know that I love qualified small business stock. It feels like such a major tax hack for early-stage employees and investors, and apparently Congress agrees. Embedded in this document, as section 138150, is a little ditty on qualified small business stock:
This provision amends section 1202(a) to provide that the special 75% and 100% exclusion rates for gains realized from certain qualified small business stock will not apply to taxpayers with adjusted gross income equal or exceeding $400,000. The baseline 50% exclusion in 1202(a)(1) remains available for all taxpayers. The amendments made by this section apply to sales and exchanges after September 13, 2021, subject to a binding contract exception.
There are a lot of implications wrapped up into that paragraph. Today, if you hold qualifying stock for five years, sales of the stock are not federally taxable for the first $10M in gains. That’s effectively a $2M tax savings, if you can take advantage of the full exclusion. However, if this change goes through, that potential exclusion gets cut in half to $1M. This is bad news for founders and venture funds who are the most likely candidates to have major windfalls due to QSBS, given the extreme volumes of equity they tend to hold.
Still good news for employees participating in tender offers
The good news for employees is that you can still get some benefit out of this. If you keep your adjusted gross income (which is your W2 income, plus any other income you receive, like investment/capital gains income, net of losses) under $400K in a year that you make a QSBS sale, you’ll still get the full 100% exclusion. This is pretty restrictive, because it means you’ll have to do some pretty intense tax planning if you want to aim for those levels, and need to keep your AGI including the sale proceeds below that $400K mark, which limits the amount of QSBS benefit you can get significantly. That said, because organizations are staying private longer, and valuations are skyrocketing faster, many companies start offering internal secondary sales, also called tender offers, to help employees get liquidity sooner. Usually, these tender offers have restrictions on participation: you must have been with the company more than two years, you can only sell 10% of your vested shares, or other similar requirements. The limitation on the number of shares actually plays nicely into this QSBS tax planning -- it means you’re less likely to bump yourself over that $400K boundary, which means you get to keep that 100% exclusion.
What behaviors might this change?
The really interesting question to think through here, is what behaviors might change as a result of a rule change like this, and how might it affect venture capital and founder investment strategies?
Potentially reduced interest in early-stage investment? This feels like it could be the most profound implication here. Venture firms have been pushing larger checks earlier and earlier because the Tiger Globals of the world have been eating up growth investing returns everywhere. The growth market has gotten ultra-competitive, which has pushed other firms to raise bigger funds to deploy earlier, and the result is things like Andreessen Horowitz raising a $400M Seed fund. Venture firms like early stage investing because that’s where you find the huge returns. The payoff from being first money into the next Coinbase or the next Facebook is astronomical.
But you still have to pay taxes on those returns. So when a fund reaches maturity, and has to start distributing capital, the funds could potentially produce 50% fewer returns, meaning early-stage venture, as an investment class, could end up being a lot less attractive to LPs.
Party rounds aren’t just an angel thing anymore? We might see the Seed market tighten up significantly, as venture firms recalculate how they should be constructing their portfolios, and focus their energies on the best return on invested capital, which might end up coming from later-stage investments (towards the B/C/D rounds) after the QSBS window has closed, but it’s easier to pick winners. It would be interesting to see if the party rounds that occur among angels early on in a company's life start showing up further out, with lots of well-respected venture firms putting in smaller checks, as everybody scrapes for allocation. This is definitely not something VCs would want, as they’ll tell you that small checks are just as much work for them as big checks, but with the extreme hockey stick valuations we see these days, maybe it can still be worth it?
Proliferation of the 1045 Exchange? If you’ve ever done a real estate transaction, there’s a good chance you’ve heard of the 1031 Exchange. A 1031 Exchange is essentially a like-for-like transaction, where you sell one piece of property and then purchase another similar piece of property within a certain timeframe, and if you do everything right, you can defer your capital gains taxes until you sell the newly-acquired property. The 1045 Exchange is very similar, but for QSBS investments. If you sell QSBS, and then acquire QSBS in a different company within 60 days of the sale, you can defer gains on the investment. This enables you to stretch the gains further, since each new investment gets a $10M maximum qualification. Between this tax rule, and crowdfunding becoming a more common way of raising early-stage capital, we might see QSBS and 1045 Exchanges become a more widespread, widely understood tax mechanism. However, that’s likely to also bring additional legislative scrutiny, as well.
Changes to Retirement Accounts
The reconciliation bill also includes a whole chunk of rule changes for retirement accounts, centered heavily around the wealthy (perhaps these will come to be known as the Peter Thiel rules), but in reality, they’re likely to affect a large swath of tech workers, especially once you get to the realm of Bay Area dual-income households.
Rule Change #1 - Contribution limits on high-balance, high-income taxpayers: The first change makes it so taxpayers with more than $10M in IRA balances (across Roths and traditional IRAs) can’t contribute more into the IRA if they make more than $400K (or $450K as a married couple). This seems very squarely aimed at the Peter Thiel types, who have extremely large retirement account balances. There’s a handful of ways that people generally seem to accumulate large IRA balances:
Alternative investments: Think private company stock, cryptocurrency, real estate, art, but in your retirement account. It’s not the easiest thing in the world to do, but you can do this with self-directed IRAs (SD IRAs), which is exactly how Peter Thiel amassed his $5B retirement savings. Realistically, this is probably the only way people are going to cross $10M in a retirement account, unless they’re on Robinhood trading options out of their IRA.
Roth 401(k) contributions: This is a relatively new mechanism, since Roth 401(k) contributions have only been possible since 2006, but between employer and employee contributions, you could amass $57K in Roth contributions per year with this strategy.
Roth conversions: One of the lesser known tax rules is that you can recharacterize funds in a traditional IRA as Roth contributions, if you pay income tax on the IRA funds. This is called a Roth conversion. There are some wild tricks that people use to perform what are known as “Mega Backdoor Roth Conversions,” (yes, the name is ridiculous, and yes, this is actually what people call them) which involves making after-tax contributions to a 401(k) (which isn’t allowed by every 401(k) administrator), and then performing an in-service distribution to a Roth IRA. Remember this one for later, because it’ll come up again shortly.
Rule Change #2 - Required Minimum Distribution increases for high-income, high-balance taxpayers: This one is a big “fuck you” to retirement account abusers that have portfolios north of $10M. Required minimum distributions are typically calculated based on the life expectancy of the taxpayer, with the intent being to spread out the distributions over the remainder of their lifespan. However, Roth IRAs don’t impose RMDs currently. This means high-net-worth retirement account holders have been able to just hold onto those accounts and pass them onto their heirs, without having to pay taxes on distributions. They’re a huge estate passing mechanism.
With the proposed changes, portfolios of more than $20M have to distribute all Roth funds, or enough Roth funds to get the full portfolio (across traditional and Roth IRAs) down to $20M. Once you hit the $20M threshold, or have no more Roth funds, you’re still dealing with accelerated RMDs down to $10M, and have to distribute 50% of the amount above $10M until you have a portfolio at or under $10M. This is the government’s way of saying “we’re going to get our damn pound of flesh.”
Rule Change #3 - Reduce “substantial interest” limitations from 50% to 10%: One of the reasons that Peter Thiel was able to get away with his insane Roth IRA tactic was that a very strict interpretation of the law allowed him to use his IRA to invest in stock of a company that he did not own a “controlling” interest (meaning 50% or more ownership) in. Since PayPal had 6 founders, he owned roughly 16.6% of the company, which wasn’t considered by the IRS to be a “controlling” share, even though he was the CEO. Yeah, that’s probably a stretch. So now, Congress will resolve that by dropping the limit to 10%, which would definitely have prevented the Peter Thiel case, though some wackadoodle founders will probably try to game this one too.
Rule Change #4 - No more backdoor Roth conversions for high-income taxpayers: One of the more important retirement-related implications of the proposed bill is the closing of some loopholes that enabled large Roth balances. Roth conversions, as I alluded to earlier, are highly-popular transactions that tax-savvy investors take advantage of while their tax burden is lower (later in life, once they’ve retired, but before RMDs kick in, or potentially during a sabbatical or other gap period in employment). They’re advantageous, because re-characterizing the funds also means that instead of paying taxes on gains when the funds are withdrawn, as with a traditional IRA, the gains are all tax-free. The proposed rule change makes it so high-income earners (over $400K for individuals) are barred from Roth conversions, and after-tax contributions to retirement plans are entirely banned. No more Mega Backdoor Roth Conversions.
Rule Change #5 - No IRA investments with account holder status requirements: This is another interesting one, because it specifically targets high-income investors in a slightly different way. Most investments in privately held companies require that investors attest to being either accredited investors or qualified purchasers. It’s relatively easy, if you have a tech sector salary, to be accredited, as the only requirement is $200K in earnings ($300K with a spouse) over the past 2 years (or a reasonable expectation of earning that much in the current year). Being a qualified purchaser is a lot more exclusive, as you need $5M in investable assets. In either case, any investments that require you to be one or the other would be made ineligible for investment using an IRA. This likely would eliminate the vast majority of angel investments made through an IRA. And if you already hold these investments in an IRA (which is allowed by AngelList, for example)? Get ready for some paperwork, because you’ll have two years to rectify the situation.
Some final thoughts
The outlined changes give some significant insight into which areas of the tax code are solidly within the sights of Congress. But also, which areas are not. Interestingly, there aren’t any changes to some of the rules around which assets get step-ups in basis upon inheritance. The implication is that people who have built their wealth on the dramatic tax advantages of qualified small business stock will still be able to pass that wealth onto their heirs and avoid the vast majority of those funds being taxed.
The changes to qualified small business stock also change the calculus significantly for people who might want to early exercise their stock. The risk versus reward calculation becomes much hazier, and it further expands the gap in payoff between founders and the first employees of a company.
The big question, at the end of the day, is: will these changes become law? It still feels very unclear if the infrastructure bill (and subsequently the reconciliation bill) will actually manage to get passed. Maybe this will all be moot.
Thanks to Nick Schrock for reviewing an earlier draft of this article