Creating Jobs by Tweaking the Tax Code

November 18, 2011

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OpSpark is now DotAlign. Come visit our new blog and our new site.

Americans like simple messages, especially about complex or unsavory topics. That’s why Herman Cain got so much publicity for his 9-9-9 tax proposal. Can 6,700 pages of tax code be chopped to 2 or 3 while creating jobs and without exacerbating income inequality? Maybe. But a couple changes at the edges could do the trick too. Here’s my modest proposal as a politically independent, “job creating” small business owner.

Important caveat: I’m not an accountant or attorney. Consult your tax advisor… and/or your elected representative!

Reward Investment in Small Businesses
Much has already been said about 9-9-9. Here’s a number that no one seems to be talking about: 1202. In fact, when I sold my last business my accountant overlooked Section 1202 entirely and I had to re-file when I learned of it. The provision provides favorable tax treatment for long-term equity ownership of a qualified small business. According to SBA research, small businesses have accounted for 65% of private sector net job creation. So this is potentially a great lever for tax policy.

As more fully described here and here, if you purchase stock directly issued by a qualifying small business, and you hold it for 5 years, you can have part of the gains excluded. The stock must be held as an individual, and the small business must be a c-corporation whose assets never exceed $50 million.

At the time I sold my business in 2008, I saved a whopping one percentage point (1%) from my federal tax bill. That’s because the rules then called for a 50% exclusion against a higher 28% capital gains rate (i.e. 14% vs. 15%). Recently, however, the Obama administration upped the exclusion to a full 100%. That’s right… If I’m reading this correctly, there are no taxes due on sale of qualifying small business stock acquired in 2010 or 2011 (for up to a $10 million gain), if sold after 5 years.

Presumably this wondrous change was made to kick-start investment in small businesses. However, there are three big problems that should be addressed:

  • None of the savvy investors from whom I raised capital were even aware of this (and I’ll bet they’re representative), so section 1202 needs a PR lift in order to have the intended effect.
  • There is little to no visibility on what will happen in January 2012.
  • The rules are all or nothing instead of phasing in, so a prospective investor anticipating a 3-5 year exit is unlikely to place much weight on the 1202 benefit.

Even if the exclusion changes to 75% as it stood for 2009 (implying 7% federal because it’s 25% of the higher 28% rate), that’s still better than the almost insulting 1% federal benefit that a 50% exclusion implies.

Obama would do well to better inform the public about the pro small business changes made to 1202 for 2010/2011. And adding clarity to the situation for 2012 and beyond (plus publicizing it) would keep capital moving toward small businesses. Will it be a 75% exclusion? 100%? Also, @BarackObama, can you do anything about the all-or-nothing aspect with respect to the five year holding period?

Reward “Primary Share” Investment
I got to thinking about the 1202 requirement that only shares issued directly by the company are eligible. In other words, putting cash in the company’s bank account in exchange for shares (“primary share issuance”) gives a benefit, whereas buying someone else’s shares doesn’t count. This makes sense to me, and made me wonder whether it should be the most important public policy driver, rather than company size.

As a CFA and former banker, I definitely understand that secondary share issuance and after-market purchases allow the liquidity needed to give the company money in the first place. But the investor who created jobs is the one who put cash into the company’s bank account to kick-start hiring, not the guy who held IBM stock for a year. So why is it that, aside from the narrow 1202 rule, holding stock is treated exactly the same as buying shares from the company (e.g. primary shares issued in an IPO)? Said differently, if Warren Buffett holds IBM stock for 12 months instead of 11, how did that fuel job creation? Keep capital gains rates lower than ordinary income, by all means, but let’s be intellectually honest about the relative impact vs. seed capital investment. If capital gains are not all created equally, then there is room to use tax policy to drive economic growth while staying revenue-neutral.

Accredited Investors
One problem with affording special capital gains incentives for investing in small businesses (or, by extension, primary shares issued in IPOs) is that the 1202 benefit is off-limits to most Americans. Private investments are riskier, and so the SEC requires that investors meet accredited investor criteria. Similarly, financial advisors must ensure that IPO investments are suitable for their clients.

In practice, the biggest problem isn’t that the investor has to meet income and asset tests. It’s that entrepreneurs need to jump through numerous hoops to avoid “tempting” non-accredited investors and running afoul of the rules. Here’s a modest proposal: What if any individual could invest up to a certain amount in “risky” investments? The amount could be set at a flat level, such as $10,000, or it could be some small percentage of taxable income.

I recognize that a plenty-lucrative scam is still possible by taking in several $10k investments. But surely some simple minimum disclosure (including identity and SS# verification of the principals), could serve as an appropriately effective measure without requiring registration and Sarbanes Oxley compliance.

It’s exciting to hear that @SteveCase and others are working toward implementing these changes. In fact, the House just passed the Entrepreneur Access to Capital Act. If the bill becomes law, we could see a whole new wave of entrepreneurship.

AMT
I’ll be short and sweet here, since this issue is well-known. The Alternative Minimum Tax needs to be brought into the 21st century… or at least updated to reflect the impact of 1970s era inflation on income levels that once defined “wealthy”.

Conclusion
I’d love to see a total rethink of our tax code. However, I’m not sure that will happen without a major change to how Washington works. In the meantime, I’d settle for extending some good policies (i.e. 1202 exclusion), and being intellectually honest about which tax policies actually impact job growth. I look forward to your comments.

OpSpark is now DotAlign. Come visit our new blog and our new site.

 

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About scafaria

Vince Scafaria is CEO of DotAlign, a new way to manage your inbox. Previously he was founder & CEO of DealMaven, which was sold to FactSet (NYSE: FDS). Before DealMaven, Vince was an investment banker for Donaldson, Lufkin & Jenrette (DLJ). Vince graduated summa cum laude from the Wharton School of the University of Pennsylvania. He is a Chartered Financial Analyst.

View all posts by scafaria

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2 Comments on “Creating Jobs by Tweaking the Tax Code”

  1. floatingfrisbee Says:

    Great post Vince! I hope @barackobama is paying attention.

    Reply

  2. Ali Javahery Says:

    Hi Vince, thank you for posting this article. I did nt know about this tax break either. I have a very good CPA despite that I remember a few years back I went and bought “tax for dummies” because I feared my accountant may miss something. The tax code is ridiculously long and complicated and we can’t expect our CPA to review every provision while they re doing our taxes. I agree with everything you said except that I d like it as broad as possible. Investors, other than the initial seed investor, should benefit from the provision if they have invested for the long term. why not? But like many great ? ideas/concepts/products this tax break provision is getting lost in all the noise around us. The quantity of information out there is insane and its getting harder and harder to convince anyone of anything with merit. We are fast becoming super skeptical of any information.

    Reply

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