Qualified Small Business Stock

For the past twenty years, the US federal tax code has included provisions that allow startup investors to get favorable tax treatment on the capital gains they earn on early stage investments. These provisions are in Sections 1202 and Sections 1045 of the tax code. 

I have been in the startup investing business for the entire time that these provisions have been in the tax code and to my knowledge, I have never taken advantage of them. So that tells you something, eiter about me or the provisions, or both.

However, given the increasing amount of angel investment activity in the startup sector, I thought it might be useful to post about these provisions, solicit comments and discussion about them, and maybe we all can learn something.

Let's start with the definition of Qualified Small Business Stock (QSBS). From this excellent post on the AICPA website:

To qualify as QSBS, the stock must be:

  • Issued by a domestic C corporation with no more than $50 million of gross assets at the time of issuance;
  • Issued by a corporation that uses at least 80% of its assets (by value) in an active trade or business, other than in certain personal services and types of businesses described in more detail below;
  • Issued after Aug. 10, 1993;
  • Held by a noncorporate taxpayer (meaning any taxpayer other than a corporation);
  • Acquired by the taxpayer on original issuance (there are exceptions to this rule); and
  • Held for more than six months to be eligible for a tax-free rollover under Sec. 1045 and more than five years to qualify for gain exclusion.

Sec 1045 allows a "tax-free rollover" which means that you can avoid paying the capital gains tax if the gain is "rolled over" meaning invested back into another QSSB. I believe that roll-over has to happen within six months of the gain, which is one of the many reasons I have not taken advantage of this provision. I like to take my time in making my investments and don't like having a ticking time bomb or gun at my head when doing so. 

Sec 1202 allows for an exclusion on the capital gains if the stock has been held for five years or more. I believe the exclusion is currently at 50%, but has been as high as 100% and there is also a 75% exclusion in some circumstances.

I agree with the Kid that tax loopholes and tax giveaways are generally a bad idea and I would personally prefer a simple flat tax with no trickery and gamesmanship. However, you have to live in the world you live in. And so if you are an angel investor, these provisions can provide great value to you.

One of the problems with these provisions is figuring out if you own QSSB, how long you have owned it, if you qualify for an exclusion or a rollover, and how quickly you need to do the rollover investing. They scream out for a platform to help angel investors with this stuff. Seems like a big opportunity for CircleUp, AngelList, and the other equity crowdfunding platforms. They can collect all of this data, build the logic into their systems, and alert angel investors when and if they can take advantage of these provisions. Maybe that would make it so that investors actually take advantage of these provisions. Maybe someday I will too.

#VC & Technology

Comments (Archived):

  1. Scott Barnett

    I like the idea that startup investors can get a break for taking a risk, and as more people have the option to invest in this way, the benefits can be spread to a broader set of people. But I’m sufficiently fed up with our tax code to believe that this too will be taken advantage of by people that have the means to explore and expand the loopholes.Everyone tells me the politics are too strong to change the tax code, but do we really have to keep layering more stuff on top of this bed of crap? I know this wasn’t the intent of your blog post, but every time you write about this stuff I get frustrated – do we *really* need to settle?

    1. LE

      “but do we really have to keep layering more stuff on top of this bed of crap?”Everything is knee jerk and layering.That is why in NJ for example there are such exorbitant tax rates vs. some other states.Someone sees something that needs to be monitored or fixed because “n” people might be harmed (where “n” is some small number) and more tax dollars are needed in order to make sure it happens and to hire people to oversee it and enforce (also courts, police etc.).So over time all these things add up. Because new things are found every year to make things “better” for a small select group of people that may be harmed. And we all pay for this. And it adds up. (Am I being clear here?)People talk much about the special interests and lobbying being bad for government but they don’t talk much about some person who had a tragedy happen and then gets a law passed that increases the costs for everybody.Or some small group of people that are wronged and now we need laws to protect them.A related example to this is the “stand your ground” issue. Nobody had any problem with it until 1 person was killed because of it. Now we are spending time, money and energy to protect perhaps a person here and a person there who might be killed because we have this law. Which was duly passed after debate, right?True it sucks if it’s your kid (or you) that is killed as a result of this. But tons of people die every day from many things. We can’t simply keep writing laws and having focus such that when something big happens we swing into action to make sure that thing won’t ever happen again. Because it’s not practical to do so. (In short: Take the emotion out of these things. As if that’s going to ever happen..)

  2. William Mougayar

    Simplifying anything to do with taxes would be great. Since the idea is to fuel investments from the bottoms-up, how about simplifying it via just a fixed exemption and deduction amount, regardless of any other parameters?Canada has a lifetime $750K exemption and $350K deduction for individuals investing in small businesses. In the US, there could be variations, like higher amounts or renewable every 5 years for e.g.

    1. pointsnfigures

      Want to watch America hum? 15% flat tax. No deductions no exceptions. Everyone pays. Look out world. We’d have 6%yoy GDP.

  3. Richard

    Here is a strategy for entrepreneurs that i read about. If an entrepreneur previously organized a new business venture as an LLC, investing a small amount of his own cash and personal “sweat” equity toward the development of the business. And If also that during 2013, at a time when the fair-market value of the LLC’s assets is the premoney valuation of say $5 million, the entrepreneur converts his LLC into a corporation, thereby exchanging his LLC membership interests for newly issued stock in the corporation. This newly issued stock can potentially qualify as QSBS, and the entrepreneur can potentially qualify for the 0 percent federal tax rates on subsequent sale of his stock if held for more than five years. Moreover, the aggregate amount of gain that the entrepreneur can qualify for this 0 percent federal tax rate would be the greater of $10 million or 10 times his “basis” in such stock (his “basis,” for this purpose, being $5 million). Under these facts, the amount of gain potentially qualifying for this 0 percent federal income tax rate would be $50 million (i.e., 10 times $5 million).

    1. John Revay

      I am not sure if the $5M pre money value of the LLC would qualify as basis for this purpose – my sense is generally it is the “Tax basis” which is likely to be lower. At least for the founders – who may have gotten tax losses thrown off while the company was an LLC

      1. Richard

        Yes, unless you have a some intangible property to back up that number.

  4. Elia Freedman

    The tax code is out of control. You are right. The world we live in is the one with a mess of a tax code. But none of us as entrepreneurs have ever uttered those words and then rolled over about it.If we want to fix the lunacy that encompasses the federal government then the first thing we have to fix is how the government gets its money. The favor system — campaign donations in exchange for money and tax breaks — is what drives the spending on campaigns to begin with.Take Rich Weisberger’s comment, for example. It is a great comment and completely valid, but there is something wrong about a start-up founder spending his time playing financial games rather than focusing on a winning product and strategy.I ran the numbers at one point. With a formula like total income less mortgage interest less charitable donations less $40,000 times 20% actually nets the federal government more revenues then it has now. I’d tie the $40,000 to inflation for good measure. (And I’d get rid of the mortgage deduction and lower the percentage if I could, too.)

  5. John Revay

    Fred – It seems like some of the investments that the GothamGal and you do outside USV may be applicable.Side note – while reading your setup….The roll over provisions sound similar to some of the tax free roll overs you can do w/ real estate, sell a property – buy a new one – hopefully you have been able to take advantage of some of those provisions.

    1. fredwilson

      i have never done a rollover for tax purposesi generally pay the taxes owed and move on

      1. LE

        As someone who has observed many people spending business thinking time on tax strategies as opposed to making more money I fully understand and agree with this. All of this is time consuming.Many years ago I used to have bank accounts setup to try and maximize the interest earned on money in the bank. (This was back when interest earned was obviously much higher than it is today). I had to constantly spend time shifting money between accounts (which couldn’t be done electronically back then) and it was very time consuming. Then everything was harder to reconcile as well. I finally got rid of all the accounts and reduced to a bare minimum even keeping money in a checking account that should have been in a money market back when interest meant something. Save a ton of time that that was better spent elsewhere.

  6. LE

    I agree with the Kid that tax loopholes and tax giveaways are generally a bad idea and I would personally prefer a simple flat tax with no trickery and gamesmanship.While there are many things that are exploited to no benefit one of the reason for various items in the tax code is to get a particular behavior economically by providing an incentive or benefit that makes people or corporations do something they wouldn’t do otherwise. $$ flow to where the government thinks the good is more beneficial than the loss from the tax revenue.On a state level here are two examples:Keystone Opportunity Zones (KOZ) are specific commercial or industrial areas with greatly reduced or no tax burden for property owners, residents and businesses throughout the Commonwealth of Pennsylvania.http://en.wikipedia.org/wik…In NJ there are “Urban Enterprise Zones” where as only one bene the state sales tax is 3.5% rather than 7%:http://www.state.nj.us/dca/…When I was shopping for some appliances I purposely contacted a retailer located in one of those zones to save on the sales tax. It’s actually a big marketing angle for them.Here is a store in Orange NJ advertising the 3.5% sales tax (not the store I dealt with) touting the reduced tax:http://www.agreatertown.com…In 2001 (and some other dates this is just the link I found) PA offered no sales tax on computer purchases:http://www.macworld.com/art…While this is not exactly what you are talking about the point (in many but not of course all cases as sure there is abuse) is similar. Try to get people to shift behavior by offering incentives.

    1. pointsnfigures

      My experience is the paperwork and amt of time the biz spends in front of boards etc pleading their case isn’t worth the trouble. In Chicago the alderman controls who gets what. Talk about kissing a lot of pinkie rings.Why not just lower taxes for everyone?Because then pols lose power

      1. LE

        “Why not just lower taxes for everyone?”See now I’d rather have something be difficult so I can work hard and it will benefit me and not those who don’t want to put the effort in. Because they are paying more.On a small scale this is similar to people who use coupons and people who don’t.People who don’t use coupons wish prices “were just lower”. People who do use coupons benefit because they get a lower price because other people don’t want to put the effort in to remember coupons in order to save money.I just bought a commercial property in a town that had a county wide reassessment. The previous owner didn’t appeal the taxes because he knew he was selling. So I got hit with the tax increase while the people who appealed got their taxes lowered. The township just changed the millage same revenue divided differently. The people who put in the effort benefited at the expense of those that didn’t (I did appeal on properties that I owned of course and saved on some of those.)

  7. LE

    “I agree with the Kid that tax loopholes and tax giveaways are generally a bad idea”Here is a list of what Business Insider calls “10 Giant Loopholes that Businesses Use to Dodge Taxes”http://www.businessinsider….Here is an example of one of these “dodges”:What: “Credit for Low-Income Housing Investments”Who Benefits: “Real Estate Developers”Ok, so who else benefits: “this one gives tax breaks to companies that develop low-income housing. It’s the rule that’s responsible for so many larger new developments setting aside 20 percent or 40 percent of their units for people whose income is well below the area’s median gross income.”Exactly what is wrong with giving a benefit to someone for doing something they wouldn’t normally otherwise do exactly?Look at the other examples on this page. I’ve bought machinery as a result of the deduction for accelerated depreciation many times. There is no question that when you own a business toward the end of the tax year you have an incentive to buy (and it’s not necessarily canabalizing either) and make a purchase that you otherwise might not make. Not to mention the increased marketing and focus that goes into making you buy before a certain date. Nothing wrong with any of this and imho the benefit outweighs the negatives.On a personal tax angel you simply aren’t going to eliminate things like the home mortgage deduction w/o a coinciding big disruption to the housing market. Even if it’s phased out over time.

  8. Matt Zagaja

    Federal income tax was one of the most eye opening classes I took as a law student. The exam was also one of the most difficult. If you do lots of investing a tax professional probably can better engineer the taxes than you could. There is too much to know and that is why large corporations like GE have big departments that focus entirely on tax.I do not think it is fair to paint people or corporations that take advantage of tax credits and deductions as dodging taxes. For better or worse it is our representatives that put these provisions in the tax code and as long as someone is taking legal deductions and credits they are entitled to, they are doing exactly what we ask of them.I think the most interesting part of your post is the part where you concede confusion as to when you would take advantage of these. @domainregistry:disqus is right they are put in to create an incentive. If it’s too confusing then the ability of the tax credit to incentivize is blunted. This is why some attorneys are hoping lawyers will move towards using more plain language in interpreting them. However it is difficult to account for every situation. Unless you have a flat or progressive tax without deductions and credits there is always room to interpret something. Wholesale modification of the tax code will likely create confusion and uncertainty as all the new provisions need to be re-interpreted.Since most deductions and credits are tax expenditures (spending of federal money in the tax code) I think it makes most sense to work towards repealing them and we can incentivize the behavior we want with direct subsidies. Instead of providing a tax credit to buy an electric car we can cut a check to the manufacturer or consumer.

    1. LE

      “that is why large corporations like GE have big departments that focus entirely on tax”Re: large and “reason”.My ex brother in law was a corporate sales rep for Apple (this was early 90’s).He (like Tom Hagen in the Godfather) had only one client. Dupont, Wilmington Delaware.I said to him “wow you mean Apple dedicates 1 sales rep to deal with just Dupont?” IIRC he responded something like “well IBM has 100 reps dedicated to Dupont so…”.Anyway as far as the size of the department that doesn’t even take into account the size of subcontracted accounting and legal work.I worked for a law office in college and one of my jobs was just to fill the binders with the latest CCH tax opinions. Old rules out, new rules in. If I fell behind sometimes I was replacing things that I had replaced earlier in the day.

      1. pointsnfigures

        My buddy is one of the top intl corporate tax people in the world. He is busier than ever since the Obama re-election. He was incredibly busy before it.Taxes are not revenue generators. They are behavioral incentives

  9. mikenolan99

    JLM had a great comment a few weeks ago about Rollovers being one of the great tax shelters – allowing one to rack up tax free gains and leave the assets to the kids with a stepped up basis.I love the idea of a platform for matching QSBS with investors. Reducing friction, standardized term sheets, etc. would add a great value to both sides of the network.

  10. ObjectMethodology.com

    Excellent post !!!!.One thing though, “…or gun at my head…”, it is a law at your head not a gun. Phrases like that are what keep guns related to bad things. I know, Fred, that you’re gonna’ first think I’m taking a jab at you because of your view on guns. But I’m not. The fact is it’s a law at your head giving you the feeling of needing to hurry. As I’ve said before laws are more powerful than guns. I’m just wanting you to see clearly.

    1. fredwilson

      Its a phrase that is commonly usedThat’s all

  11. Christian Macari

    My tax professor once joked to me, “every time a politician and a lobbyist get together over a martini the tax code changes.” I agree our tax code is full of special interests (cool fact, it is about 70,000 pages long). Politics aside, I do not have any tangible experience to offer, however I just studied for the regulation (tax) portion of the CPA exam and QSBS was included in the material. I was curious if you guys were taking advantage of this or not. I figured you would be. According to the JOBS act you don’t have to add back the exclusion, effective until Jan 1. 2014. Before that you had to add back 28% of the exclusion and later 7% to AMT. Say you excluded $50mil (from a big exit that qualified), you would have to add back to AMT $14mil (28% of exclusion). AMT for high tax bracket individuals is 28%. You would end up paying $3.92mil on the $50mil exclusion which is roughly 7.8%. Not bad for adding it back to AMT. Of course you do not add back the capital gain that wasn’t excluded, because it was already taxed. I know I just reiterated a lot from the link that Fred posted by the AICPA, but I thought I would clarify the AMT portion and add my 2 cents of theoretical experience. If you choose to take the QSBS exclusion, whatever amount of the gain you did not exclude will not receive preferential capital gains treatment and more likely than not will be taxed at 28%, as of 2013.Another section that is worth noting, especially if you haven’t been taking advantage of it is section 1244 (worthless small business stock). I would imagine this applies to the angel investors. You can include up to $100,000 of the loss as an ordinary loss (fully tax deductible) if you are married and $50,000 if you are single. The rest of the loss is offset against your capital gains. In order to qualify you have to have given cash or property in exchange for the corporations first $1mil of capital stock. When a startup investment becomes worthless, keep this in mind. Section 1244 is meant for giving you a break for taking the risk early on.Also, you could still qualify for the 75% and 100% exclusions if you acquired the stock during the given time period. 2/18/09-9/27/10 for 75%, 9/28/10-12/31/11 for 100%. It is the time you acquired the stock, not when you recognize the gain. Interesting read. I really thought you guys would be on top of this already!

  12. Aaron Klein

    The tax code is a lot like legacy enterprise software. There may be a lot of powerful features in there, but it’s so arcane, difficult and impossible to navigate, nobody can figure out how to use it.We really need to pass the Web 2.0 SaaS version of the tax code, and just let people opt into whichever tax code they prefer.

    1. pointsnfigures

      Read America 3.0

  13. jason wright


  14. jason wright

    dead ringerhttp://upload.wikimedia.org…

  15. JLM

    .The challenge with any economic incentive which is driven by tax policy is the lack of marketing to sell the idea which is driven by the sheer complexity of it all.Complexity of one type to overcome complexity of another type — it’s like having to learn Greek to understand Spanish.The bottom line — as shown by Fred’s comments — is that it doesn’t work. Fred doesn’t intend to even invest the time to research whether it works or not.As a result the objective of the policy — to increase investment in enterprises which will create jobs (jobs being the code word for taxpayers, really) — does not have a freakin’ chance of being achieved. Not a chance.On the other hand, states like Texas play trump with no personal income tax. By distilling the comparison to a binary comparison — either zero or one — the complexity conundrum is defeated and folks can make “good” decisions.The fact that almost 1.5MM Californians have moved to Texas in the last 6 years speaks for itself if one embraces the notion that part of their motivation is to escape an increasing state income tax burden and high cost of living and difficult regulatory environment.Complexity cannot defeat complexity but elegant simplicity can play trump.The ability to see the linkages between cause and effect requires a bit of thought and not knee jerk reasoning.A case in point is the recent discussion about punishing the State of Florida for the Zimmerman case outcome as if the decision of 6 jurors in a little town like Sanford, Florida should be a relevant input in the decisions pertaining to the balance of the state.We need to clean up the tax code — and thereby unearth tax incentives to grow — with simple solutions not more complexity.JLM.

    1. LE

      “…not knee jerk reasoning. A case in point is the recent discussion about punishing the State of Florida for the Zimmerman case outcome…”Wow do I ever agree with your point.That said I wonder how much of this is simply amplification by the media of a particular bias that they have? (In other words how many people even think this way?)I was watching a Morgan Spurlock CNN “Inside Man” on gun control [1] and someone made a point that if background checks were enhanced then the government would know what guns people owned and could confiscate them. While this isn’t a concern of mine and (knowing what I know) I think the benefits outweigh the downside, I can certainly see the point of view and would consider it in my thinking if I was asked to decide something like that. And maybe I would change my mind.But here’s the thing. Until I had watched the report I had never even thought of that angle. To me on the surface I couldn’t understand any reason why it would matter. Now I at least have a reason to consider.http://insideman.blogs.cnn….Obviously the tone, wording, placement and prominence of any news report greatly adds to how seriously people take a given issue.[1] Definitely worth a watch.

      1. JLM

        .Not to get back on my gun rant but the real problem with almost everything that is proposed by the left as it relates to guns is that it simply would not prevent the tragedies that they contend have triggered this heightened sense of concern.The issue with guns is simply CRAZY people with guns not guns.We need a list of CRAZY people to be created, maintained and used powerfully in real time with big data.If you turned this over to Amazon or VISA they would be able to track any CRAZY person who ordered a weapon or ammo within less than 10 minutes and take the appropriate action.The man hours used by law enforcement to respond to tragedies if redeployed to simple prevention would have eliminated all of the recent tragedies, so it is not a “mo’ money” problem.The left does not want a solution, they want to take my guns.JLM.

    2. sigmaalgebra

      > Complexity cannot defeat complexity butelegant simplicity can play trump.Yes.For an individual or company reallyminimizing taxes would be forbiddinglycomplex. There’s some math for a solutionin principle outlined in, say, http://www.avc.com/a_vc/201http://www.avc.com/a_vc/201…While that math can be nicely easy andquite valuable to apply in some carefullyselected cases, and there might be such acase with taxes, for minimizing taxes withmuch generality, applying that math wouldbe just at, over, or way over the boundaryof what is doable now in algorithms,software, computer power, and enough easeof use to be practical.What I don’t get is the attitude of thevoters: The voters have all the power onecould ask for, and just by pulling somelevers in voting booths can shake DC hardenough to level it.And I don’t get California: They want to’clean up’ gasoline powered lawn mowers!No wonder CA people are moving to TX.So, why the voters put up with the taxcode, the NSA and the secret FISA courttracking mud over the Fourth Amendment,tricky efforts to cancel the SecondAmendment, SWAT teams breaking down doorsand shooting pet dogs, going after poorAaron Swartz like he was a dangerouscriminal just for making excessive use ofthe MIT literature search tools, absurdforeign adventures that consume US bloodand treasure for over 10 years, theFederal government growing like a weed andbecoming its own constituency for itsgrowth at the expense of everyone else,Congress meddling incompetently in theeconomy and, thus, being the main driverfor the housing bubble and the resultingcrash, and now the threat to ruin the UShealth care system (of course the carewill not be as good, but you have tounderstand the cost will be much higher)instead of voting the bums out I don’tget.Yes, Saddam was a thug; in Iraq, what elseshould we expect and want? He talkedabout WMDs but wasn’t really making anyprogress with them (which we should haveknown). He didn’t have any significantcontact with Al Qaeda, and he didn’t likeAl Qaeda, Iran, or Syria. And with Saddamthere weren’t any car bombs going boom.Likely the number of violent deaths permonth in Iraq has been much higher sinceGulf War II. Or as General “Mad Dog”Mattis said recently, “Occupy a country.Bring down a statue. Now what? Know whatI’m saying?”. I know; I know; we gaveIraq “democracy”, a constitution, a freeelection, and led them in singing Kumbayahuntil some more car bombs blew up.Now The Chinese are getting a lot of theoil. The Iranians are flying oversupplying Syria.What’d we accomplish for our NPV $3 T orso? $1 T here, $1 T there, and after awhile it adds up to real money.At one time, the US Federal government wasfunded almost entirely just by tariffs.Then the US economy was growing like aweed.Projects the Federal government doesn’tstart they don’t mess up. Money theydon’t spend they don’t waste.Now they want to move DHS into the old DCSaint Elizabeth’s Psychiatric Hospital.Sounds appropriate enough. Hopefully TSAwill be the first inmate. Alas, they wantto spend $4.5 billion on the move.I don’t know why voters put up with thisnonsense.

      1. JLM

        .I agree more with you than you do with yourself.The problem is that elections are no longer about issues they are about abortion, gay rights, entitlements and defense.The Republicans and Democrats share equal blame. Folks do not recall that wedge issues like abortion have always been great for Republicans. The recent business in Texas has done nothing but strengthen the Republican majority and brand.The Democrats get their fair share of the blame for their ruthless and highly skillful use of incompetent voter turnout. They don’t even attempt to argue issues, they just turn out class distinction identified voters and let them vote the class warfare angle.I suspect that the Republicans will win the Senate in 2014 and this will likely be their last chance to right the ship.My 95 year old Father reminds me from time to time that Prohibition lasted for 13 years before being repealed. Perhaps Obamacare can also be repealed. We shall see.JLM.

        1. sigmaalgebra

          You mentioned abortion, and that’s a primeexample. Whatever view one has onabortion, there is an argument, a fact, asimple, dirt simple, rock solid fact: TheSCOTUS decided Roe v Wade over 40 yearsago, and the chances of changing it withinthe next 40 years are slim to none. Or,when get 2/3rds of the House, 2/3rds ofthe Senate, and 3/4ths of the states, letme know. In the meanwhile, for changinglaws on abortion, f’get about it.To me, that little argument is rock solidand easy enough to understand in gradeschool. Still, ‘abortion’ appears to be amajor issue in elections.I’m not getting it on why there are enoughpeople who don’t get that argument onabortion, refuse to f’get about abortion,and won’t pay attention to, say, theeconomy for there to be any significantrole for abortion in elections.If elections were a BBQ sandwich, thenthere’d be no meat, not TX sliced brisketor Memphis chopped shoulder.Here’s my excuse: The MSM needs eyeballsfor ad revenue. So, they keep the levelof discussion low, low, low to make iteasier to push ‘stories’ on totalnonsense issues and grab readers by theheart, the gut, and below the belt.Okay, the MSM is free to do that, and I’mfree to turn off the TV. As I wrote onThursday, July 25th, 2013in http://www.avc.com/a_vc/201…”TV? High phooey.” and have the set topbox that reduces my ISP charges sittinghere without a TV ever being connected.In strong, astoundingly overwhelminglystrong contrast, never, not in 10 years,not on all the ‘business’ TV shows on allof US TV, will we even once get adiscussion of anything in business asimportant and full of good content as thediscussion of QSBS and taxes in thisthread on this blog today — never.Beyond belief.More generally, I get my information fromthe Internet. TV? Not a chance. Anewspaper? From an attempt to make ituseful, it would just get ink on the backends of my two kitty cats, and they areclean little animals and wouldn’t likethat.I’m just not getting it just why peoplecontinue to watch the TV news or how theMSM people can keep eyeballs by talkingabout such trivia such as abortion insteadof something really important like theeconomy. And I flatly don’t get it why Wdidn’t know Saddam was making no realprogress with WMDs. And I’m not gettingit on why so many people who should knowAfghanistan well keep talking aboutdemocracy, democracy, democracy in thatcountry.Sports on TV? I’d like to watch but can’tsee enough. It’s too fast and otherwise ablur. In NBA ball, I can’t detect thestrategies or tactics. Now, if the NBAwould have 24 HD slow motion cameraswatching the action and put it all on theInternet so I could walk through theimportant possessions slowly, with clearimages, with expert commentary, then I’dwatch, including the ads.In the meanwhile the Eric Lander lectureon how DNA gets replicated is beyondbelief; DNA Replication http://www.youtube.com/watc…So, consider some DNA in a circle andreplicate it. Now there are two copies ina tangled mess. There’s a theorem intopology that says can’t pull the twocopies apart. Somehow two teenagers inthe back seat of an old Buick manage to doit often and easily enough. How? Near18:40 there’s an enzyme Topoisomerase IIthat crawls along, sees a cross over,snips the double strand, pulls the ends tothe other side of the cross over, and putsthe ends back together. Amazing. F’getabout the NBA!Just found an even clearer description http://www.youtube.com/watc…How stuff like that Lander lecture couldshare the planet with MSM news and the twoparties playing the class card and theabortion card manipulating the voters toput up with DC is beyond me. I’m notgetting it.

  16. Jon Smirl

    The older form of the 1202 stock exclusion from around 2000 is worthless. I had an exit that qualified. By the time the AMT got done messing with me I would have been better off if it hadn’t been 1202 stock. The AMT makes you lose other deductions (like the ones for state income taxes). So the transaction ended up at the 14.7% AMT rate when cap gains were 15%. But I lost the equivalent of 2% in deductions so I actually paid 16.7%.. At the time 1202 was mandatory if you qualified, you could not elect to be non-1202.Really nice of the government – advertise this great tax break for entrepreneurs then when they take advantage of it make them pay a higher effective tax rate.

  17. Jon Smirl

    Another area that really hurts smaller entrepreneurs is the elimination of income averaging. When I am in the startup phase I often don’t have enough income to consume my deductions. So I just lose them. Sometimes I even trigger the AMT in these small income years which wipes out even more deductions.Then I have an exit and max the scale on the other end. So the entrepreneurs is slammed in both parts – the lean years by losing their deductions (mortgage, property tax, state tax, etc). Then they end up in a top bracket probably with AMT eliminating deductions again.Bringing back income averaging would make this more fair.

    1. LE

      “When I am in the startup phase I often don’t have enough income to consume my deductions.”What are some of the deductions you have that you can’t deduct? (I’m not doubting what you are saying but curious what items you can’t book over time?)

      1. Jon Smirl

        Mortgage, property tax, state income tax, investment expenses. In high tax states it isn’t too hard to run up $250,000 in deductions. If you have a lot of these and a small income you’ll trigger the AMT and lose most of them.That’s exactly what happened to me this year. My deduction almost exceeded my income. I don’t think there is any way to recover these once they are lost. Please tell me if I’m wrong. .I’m able to handle this because I can spend principal to cover the expenses.

        1. LE

          “Mortgage, property tax” You’re saying your home mortgage and property taxes or are you saying a mortgage on a business property that you already own or that you purchase for the new venture? (If on a home my quick calcs seem to show a pretty expensive property if you are paying something like that.)And what are the investment expenses?

          1. Jon Smirl

            It is a very expensive house with a large mortgage on it.Investment expenses are portfolio management fees that get charged even if there aren’t a lot of transactions going on in the portfolio.Another one that annoys me greatly is the inability to deduct my family’s health care premiums since I am personally paying for them and not getting them via an employer.You can get into these situations when you both fund the start up and are a principal in it. It is silly to give the startup money for things and then have it give you the money back. All that does is incur even more taxes.

          2. Jon Smirl

            I just looked up the house across the street. He is a big time Hollywood producer. Way better house than mine. He is paying $182,000/yr in property taxes and he only use the house two months out of the year.

          3. LE

            “Another one that annoys me greatly is the inability to deduct my family’s health care premiums since I am personally paying for them”There totally has to be a way to game that one.What I have found over the years is that it pays to know as much as possible since most accountants are not going to tell you things that you can do vs. the probabilities. So armed with what you know and what the accountant tells you you can make the proper decision on what to do. Most accountants are not going to bless or encourage a risky strategy. But you have to weigh the risky strategy vs. the chance of the risky strategy being uncovered and something happening. (Which is not the same as cheating by the way.)

        2. JLM

          .I am not one to take tax advice from but your situation screams out for the creation of a family LP as a tax efficiency and estate planning vehicle.By funding deals through an LP and using it to simultaneously pass wealth along to children — in particular with no/low basis, high ownership attribution to children coupled with lifetime limitation gifting — you may be able to separate gains and expenses and thereby not create the AMT issue at your personal return level.The LP may be able to, under very tightly controlled and structured circumstances, accumulate business expenses as a loss carry forward and then apply them to future gains.I know this can be done but it requires a very good tax, estate lawyer/accountant team and some real planning.When coupled with use of real estate to create predictable interest and depreciation deductions at the LP level, it can be a powerful tool.Remember also that real estate, and certain other assets, when inherited by heirs is subject to a one time step up in basis.This may also require some trust work to move assets out of your estate while you are alive. The use of trusts is also a way to compartmentalize the ownership of assets and thereby prevent the commingling of income and deductions but beware that trust tax rates are very high.More than this I am reluctant to say publicly.JLM.

    2. PhilipSugar

      I agree completely. I just hate making the tax code more complicated.But it really sucks when you are paying other people’s full salaries and paying yourself nearly nothing.Then when things start going well people say you are rich and should be penalized.

  18. Vasili Pupkin

    Fred, check this outhttp://www.builtinchicago.o…

  19. pointsnfigures

    Does this also apply to gains from funds? For example, USV LP’s technically had an investment in Tumblr at angel levels. Does the tax benefit pass through? Seems like in the spirit of the law it should.Agree on taxes and loopholes. I also agree with Milton Friedman. I am for lowering taxes at any time for any reason.

    1. fredwilson

      i think so, but as i said, i’ve never used it

    2. LE

      “I am for lowering taxes at any time for any reason.”Going to be hard because of new efficiencies. I mean a long long time ago a guy got paid to sweep up the floor on an exchange, right? Don’t need that guy anymore so he will just end up being on public assistance. Or unemployed and develop health problems.I heard that legal secretaries are a dying breed. So we have increased salary of (employed) attorneys and less of that high per hour rate being sliced off like a whisp of cheese and paying for the lower middle class lifestyle someone else.I used to be really really against unions (I still am just not really really against). I have come to realize that it’s not so bad because it’s a form of taxation that keeps up a minimum lifestyle of a certain blue collar class and keeps people from revolting. Took me a long time to realize that if, like anything else, it’s controlled and done in moderation it’s actually better than the alternative (a bunch of unemployed people).My father in law got to retire early on a great NYC teachers union pension that everyone is paying for. If he didn’t have that pension he would be more of a burden on me and my wife (in theory that is).You might enjoy this given your background. Inappropriate but some of it is pretty funny:http://gselevator.wordpress

      1. pointsnfigures

        Follow them on Twitter. Used to be funnier. Nothing anyone tweets will ever be funnier than the hijinks on a trading floor. There were NO sacred cows. Politically correct and easily offended need not apply. Purest form of raw capitalism ever.Disagree on unions. Private ones if left to actual choice are up to employees. Public employee unions are an abomination.I should write a trading floor book. Would make a helluva movie.

    3. JLM

      .Most LPs are likely to be tax exempt entities.JLM.

      1. pointsnfigures

        that’s not always true. family offices, wealthy individuals, corporations, fund of funds…

  20. John Frankel

    Fred, thanks for helping educate folks on this important piece of legislation. It was pretty immaterial until President Obama kept his campaign promise to reduce the effective rate from about 14% to about 7% from February 2010 and then to 0% from September 2010. It has been kept at 0% either proactively or retroactively since. it goes back to about 14% at the end of this year.As the effective rates pass on through to limited partners and as the cap is $10mm per partner or 10x their gain (whichever is higher!) I have felt that it has been important to track this for our LPs as a fiduciary for them.Tax planning does not impact our reporting returns, but it certainly helps our LPs. Everyone should and must pay their due taxes, and though I strongly prefer a tax regime with no deductions, that is not the world we live in. We live in a world where our government wants us to do certain things and tries to incentivize us via tax credits and deductions.

  21. BartonFarm

    In my view, this is landmine territory, though it could well be lucrative. USV and other funds are submitting tax data for their investors to the IRS, something new in their reporting (not sure which law started enforcing this), just like a brokerage account reports dividends and gains. QSSB allows the gains from a startup to be “excluded from income.” If the underlying fund has reported income on your tax ID (SS# or EIN#) and the individual payor chooses to elect QSSB and not report it, IRS computers will automatically red flag that, and the individual will get a letter and (likely at such money levels) an audit. It would take a brave fund to claim that all their gains are QSSB to help their investors, if the IRS would challenge them and win the penalties could be enormous. That is why the best sales of a startup are to the Exxons and IBMs of the world, such that an investor can turn a risky stock into a quasi bond without paying taxes, and then do all the proven and legal tax minimization techniques to maximize the ultimate cash. Sadly, with all-in tax rates at the 50% range, it is very expensive to ignore tax planning, even though it provides no economic benefit to the country or human kind, and is the most boring thing for anybody with entrepreneurial fever. In my view, capital gain tax on any stock owned for 10yrs or more should be zero. Investing in our country for the long term is the most patriotic thing one can do, and should be rewarded handsomely.

  22. The Alpha Enterprise

    Nice post! It will surely help a lot of people.

  23. BartonFarm

    btw, this only applies to companies with less than $50m in assets.

  24. fredwilson

    i heard that from Naval at AngelList as wellthat means it may be even harder to get the benefit of this exclusioni am going to dig into it

  25. Roddy Davis

    Couple of technical points to supplement the conversation:1. Gains on the sale of 1202 stock issued between Oct. 2010 and the end of 2013 and held for more than 5 years are 100% excluded from regular income tax and are not subject to AMT – up to $10M per taxpayer. The exclusion doesn’t require an election. Lower percentage exclusions are available for 1202 stock acquired in earlier years – but those gains may be subject to AMT.2. Stock acquired in exchange for cash, property, or services is eligible for 1202 exclusion. This might be a reason to exercise options or conversion rights before the end of 2012.3. If 1202 stock is exchanged for stock in another corporation in a merger-type transaction, the stock received in the merger will be eligible for the exclusion.4. Each partner in a partnership is eligible for 1202 treatment on any 1202 stock bought by the partnership – in accord with the partners’ percentage interests at the time of the partnership’s investment.5. The $10M exclusion is “per taxpayer,” so the earlier suggestion of using a family limited partnership might be a viable technique to obtain multiple exclusions for an investment that will generate significant taxable gains. In fact, stock that is gifted to family members should retain its 1202 eligibility in the hands of the family member.6. The 1045 roll-over is elective (and not automatic) and the re-investment in new 1202 stock must be made within 60 days of the sale of the 1202 stock held for more than 6 months but less than 5 years. So, use of this election is difficult – but not impossible. It might actually be easier for an active investment partnership to qualify than an individual investor.7. The 1202 exclusion can be claimed on amended returns for 2012, 2011 and 2010 – so if one had significant gains on stock that might qualify as 1202 stock, it might be worth getting a tax specialist to explore the potential for refunds.

  26. pointsnfigures

    My experience is the phrasing is a lot bigger than the hoop you have to go through. What’s that Bible verse about a camel through the eye of a needle?