These reforms will be an enormous benefit to startup founders and early-state employees. Experts like Kreischer Miller’s Stephen Staugaitis and Janus Henderson’s Ben Rizzuto highlight that these changes could provide substantial tax savings and create new opportunities for capital formation.
The OBBBA increases the exclusion cap for Qualified Small Business Stock (QSBS) to 100 percent. This amendment will save shareholders at least $1.2 million in taxes by raising the cap on expensing from $10 million to $15 million. This is especially important for entrepreneurs who want to get the most bang for their buck and deal with the added intricacies of corporate-level taxation.
Incremental Changes in Tax Legislation
The OBBBA continues the legacy of the 2017 Tax Cuts and Jobs Act, which brought about unprecedented changes to tax policy. The earlier legislation definitely set a different, new precedent. Unlike the OBBBA, the OBBBA opts for incremental but significant improvements to existing frameworks, as opposed to the blunter shock of completely new frameworks.
The biggest single change allows you to dispose of your stock sooner while continuing to reap tax benefits. The old minimum holding period was reduced from five years to only three years. This flexibility will allow founders and early employees to cash out over time earlier while maintaining access to favorable tax treatment.
“The minimum holding period for the stock (to take advantage of QSBS exclusions) is three years, with five years or more garnering the biggest tax break.” – Stephen Staugaitis
The corporate tax rate does not change from the current unchanged rate of 21%. This lack of consistency determines how businesses plan their financial practices. Rizzuto underscores that the permanent 20% Qualified Business Income (QBI) deduction really increases the business climate. This tariff reduction is a major boon to American businesses, especially those in the technology, manufacturing, and retail and wholesale trades.
Benefits for Founders and Investors
Tax experts have described the QSBS rule changes as the most dramatic amendment made by the OBBBA. By increasing the exclusion cap, investors can raise bigger amounts of capital, creating a greater ecosystem for successful startups to flourish.
Alison Flores from H&R Block emphasizes that “the increased exclusion cap allows investors to increase their investments.” That influx of capital can help enable those businesses to take advantage of new opportunities to grow and drive more value to their stakeholders in the process.
“At the same time, qualifying businesses will be able to raise larger amounts of capital. Generally, this provides an opportunity for these businesses to pursue growth opportunities and potentially create more value for stakeholders.” – Alison Flores
Furthermore, seasoned entrepreneurs are encouraged to seek assistance from tax, accounting, and legal teams to identify potential risks and capitalize on new opportunities arising from these changes. Rizzuto states that “for founders and early employees, it offers the ability to shield a larger portion of gains, do more robust estate planning, and have more flexibility in choosing when to realize a gain based on the new, tiered exclusion system.”
Addressing Corporate Structures and Future Implications
The form of a corporation also has implications for how profits are taxed and whether they can be easily extracted. C corporations face severe tax consequences if owners wish to take out the majority of profits annually. Thus, business owners need to do a thorough analysis of their corporate structures.
“Owners looking to extract most of the profits from the business on an annual basis will feel a heavy tax friction along the way as a C corp.” – Stephen Staugaitis
In light of these complexities, some entrepreneurs may consider transitioning from C corp structures to Limited Liability Companies (LLCs) to alleviate pressure from government requirements. Flores points out that “some people just don’t have the patience for some of the government’s requirements of the C corp, so maybe they need to be an LLC.”
This expansion of QSBS is especially important for startup capital formation at this moment in time. Rizzuto asserts that “the QSBS expansion is a game-changer for startup capital formation,” highlighting its potential impact on emerging companies seeking rapid growth.
Valuation versus Aggregate Assets
Another important factor in this rapidly changing environment is the difference between valuation versus aggregate assets. To illustrate this point, Rizzuto uses an example from the startup world where a high valuation does not mean a company has tangible assets.
“A startup could be run out of a garage, have a couple computers, and a great idea, which could receive a high valuation. Just because the valuation is high doesn’t mean that there is an equal amount of assets.” – Ben Rizzuto
This clear distinction is critical as entrepreneurs set out to figure out their economic plans with these recent changes. The impact of these regulations could radically change the way early-stage startups seek out investment opportunities and evaluate their growth potential.