This column originally appeared in the July 2016 issue of Venture Capital Journal

By Sam Cohen, Tim Curt and Sandy Grippo

Many participants in the venture capital industry are familiar with Section 1202 of the tax code, which contains the Qualified Small Business Stock rules. These rules can provide a valuable exemption from capital-gains taxes for patient investment in early-stage startups. In addition to encouraging direct investment in startup companies, the provision also has the potential to be a powerful incentive to directly encourage entrepreneurial activity because it applies to founder’s stock. But despite its valuable appearance on paper, QSBS is dramatically underutilized in the entrepreneurial ecosystem.

The rules are so complex as to be unworkable in most situations:

  • The documentation requirements are too onerous for startups, which must prioritize investing in the growth of the company over the significant back-office infrastructure that they need for compliance.
  • The incentives are not aligned with the responsibilities to make complex determinations.
  • The eligibility size limits haven’t been updated since the provision was originally passed in 1993, and in some situations work to retroactively disqualify the most successful companies if they raise too much capital.

Particularly in light of the high failure rate of startup companies, the incentive value of QSBS is blunted because of the significant risk that a seemingly qualifying investment can be subsequently disqualified for technical reasons. Fortunately, the intent of policymakers in creating a robust incentive for investment in early-stage startups has been made clear by previous legislation improving QSBS, several bills extending those improvements, and most recently legislation that made them permanent.

Previously the combination of a partial-capital gains exemption and the Alternative Minimum Tax severely limited the benefit that the QSBS rules could provide. An effort in 2010 to fix this was only temporary, making it hard to predict whether even maintaining the documentation was a worthwhile effort. In December 2015, with the help of lobbying by the National Venture Capital Association  and other groups, Congress made these improvements permanent, setting the stage for a more impactful startup investment tax incentive. While years of uncertainty caused many in the entrepreneurial ecosystem to write off the provision as not being worth the effort, the December legislation is causing some to take a second look. Now is the time to finish the job and enable the provision to drive more investment to our country’s startups.

The current version of the QSBS rules provides that by holding an investment in a qualified small business for five years or more, an investor can exclude up to the greater of $10 million in gains or 10 times the investment in the stock from capital-gains taxes. A QSB is defined as an American C-corporation with less than $50 million in assets. To defend against tax avoidance by those looking to unfairly take advantage of 1202, Congress and the IRS created a labyrinth of strict rules on what qualifies as a QSB. To demonstrate that a company is a QSB, the taxpayer (i.e., the shareholder claiming the benefit, rather than the company upon whose facts the eligibility rests) must be able to produce a host of documents that show continuous adherence to these rules during its holding period, with the burden of proof always on the taxpayer to prove that the investment was in a bona fide QSB. While combating abuse is important, Washington essentially wrote a law to help startups but created eligibility rules to which the accounting department of a Fortune 500 company would be hard pressed to adhere.

As chief financial officers of major venture capital firms, we are all too familiar with the pain of trying to figure out whether portfolio companies that are perfectly in line with the spirit of QSBS are actually eligible by the letter of the law. So, working with the National Venture Capital Association, we formed the NVCA 1202 Reform Working Group to recommend proposals to make Section 1202 more effective in achieving the intended goal of encouraging investment in entrepreneurship.

We have had a front-row seat to the jobs and economic growth created by growing ideas into successful companies, but don’t take our word for it. A number of research papers have shown just how powerful the entrepreneurial ecosystem is as an economic engine. Take, for instance, a 2010 National Bureau of Economic Research working paper that analyzed data from the Census Bureau’s databases. It found that “startups account for only 3 percent of employment but almost 20 percent of gross job creation.” Another study from 2010 by the Kaufmann Foundation, using the same dataset, found that startups “create on average 3 million new jobs annually.” The study also found that “without startups, there would be no net job growth in the U.S. economy.” And a 2015 study by Stanford University found that of all companies that have gone public since 1974, venture-backed startups accounted for fully 85 percent of the investment in research and development by those companies.

To enable the QSBS rules to fulfill the mandate of supporting investment into the entrepreneurial ecosystem, Congress must simplify the rules, ease the documentation requirements (or better align the incentives for maintaining them), and update the size limits. We have put together 11 ideas to improve 1202. We propose one set of reforms to simplify the rules and increase certainty for startup investors, another set to expand the eligibility of Section 1202 to update it to the realities of today’s economy, and a third set of reforms to a related provision, Section 1045, which allows 1202-eligible investments to be rolled over into new companies.

Most notable among these proposals is one that would change the current requirement that a company continuously document its eligibility during an investor’s holding period to a more common-sense annual test of quarterly averages. Our proposal, similar to how the REIT rules work in the code, would enable 1202 to adhere to the spirit of the law because it would look at a more comprehensive picture of the company. This contrasts with the current test, which makes many startups ineligible simply because they can’t afford the time and paperwork to keep up with it. And much like the REIT rules, a QSB would declare its status as such on its tax filings, permitting eligible shareholders to rely upon the company’s declaration without needing to negotiate with the company over access to its records and without needing to make independent determinations at the shareholder level.

Another rule change we propose would clarify that the tests should be necessary only during the initial five-year holding period. We strongly agree that policy should encourage long-term investment. But to truly encourage investment in startups, the policy should ensure that the taxpayer receives a benefit once the policy objectives are met. Right now, if a taxpayer holds QSBS for 10 years, and in year nine the company grows beyond the size limits, the taxpayer loses the entire value of the benefit. That’s counter to the objectives of 1202 and damages the provision’s incentive power. After all, we want to encourage the creation and growth of new companies that create jobs and generate badly needed economic activity for the country.

We also propose that the company-size limits be updated and indexed to inflation. The $50 million limit today is the same as it was when Section 1202 was first enacted in 1993. Meanwhile, inflation has eaten away at the company-size limit each year at the same time that innovation has become more expensive. These changes would ensure that the size limits more appropriately reflect current economic realities.

These are a few of the ideas we propose, and we look forward to working with NVCA to present them in Washington. Policymakers must begin prioritizing creation of new companies because the rest of the world is catching up to our lead in entrepreneurship. As recently as 1994, more than 90 percent of venture capital investment went to U.S. companies. In 2015, that number dropped to 54 percent. It’s time for Congress to reform Section 1202 so it can more effectively encourage investment in entrepreneurship. This would be a powerful move to shoring up American leadership in this field.

Sam Cohen is chief financial officer at New Enterprise Associates, Tim Curt is managing director and a member of the executive management group at Warburg Pincus, and Sandy Grippo is chief financial officer at Bessemer Venture Partners.