A New York Times article published on December 28th, 2021, by Jesse Drucker exposed various practices that contort the Qualified Small Business Stock (QSBS) tax exemption. The QSBS tax benefits were originally put in place to support the startup ecosystem, bolster job creation, and contribute to the rebuilding of the national economy. However, these new practices utilize the benefits of the QSBS tax code in a manner not initially intended. Expressed outrage over these practices came to life in over 1,100 comments that the article received within days of publication.
This article echoed sentiments also felt by legislators, including PA Senator Bob Casey. When Senator Casey described why he supports modifying QSBS he noted,
“Some investors are multiplying the amount of income they exclude from taxation by engaging in manipulative practices such as ‘stacking’ or ‘packing’ by which investors pervert the intention of Section 1202 to avoid fair taxation.”
While these practices may run counter to the intent of QSBS, are they substantial enough to overhaul QSBS and reduce its impact in elevating the startup ecosystem which provides most of the new jobs in America?
A Brief Synopsis of Drucker’s Take
Drucker follows the trajectory of the QSBS tax break from its conception in the 1990s to its current utilization in the startup marketplace. The tax code was originally enacted to incentivize investors to contribute capital to small businesses to boost the economy and job creation. While QSBS was initially slow to take off, it became more “mainstream” over the last decade. Now, founders and venture capital investors alike see the benefits for their qualified companies and investments.
The article also threads a story about startup entrepreneur David Baszucki, the founder of Roblox. In 2004, Baszucki started a small video-gaming platform that qualified for the QSBS tax exemption. However, over the last decade, this gaming platform has grown exponentially. The company is valued at $60 billion, making Baszucki’s worth an estimated $7 billion. This particular story is causing some to question why the tax exemption can still be fully utilized by the wealthy and ultra-wealthy when the benefits were to bolster economic growth by incentivizing investors and founders to build small businesses.
There is a short answer in light of this looming question. The vast majority of businesses that start with hopes of qualifying and gaining QSBS tax exemptions do not end up becoming multi-billion dollar companies. For this very reason, there is only one Amazon, one Walmart, and one Apple. Yet to exclude the QSBS tax incentive because of the rare chance of a multi-billion dollar company is detrimental to the 627,000 businesses created each year.
Yet another question relates to how some venture capitalist investors find the opportunity to include their family and friends when it comes to benefiting from Section 1202 tax exemptions. This practice is where the explanations of “stacking” and “packing” must be fleshed out.
A Closer Look at “Stacking”
“Stacking” refers to the method of transferring one’s shares to another taxpayer through some investment vehicle—most commonly through trusts—in which case, now that taxpayer will be allowed to utilize the same tax benefits as the grantor. The original holder and the trusts each benefit from the greater of $10M or 10x basis exemption limit, thereby multiplying the potential tax savings.
Drucker notes how in the case of Roblox, Baszucki and his wife, Jan Ellison, used this strategy. As an act of estate planning, the couple gifted shares to their children and additional family members. This preemptive move could also help them avoid millions of dollars in estate taxes and gift taxes because it occurred before Roblox stock was worth very much. Since the company met qualifications for QSBS tax exemptions, the recipients of the gifted stock could also qualify for millions in profit without capital gains tax.
Gifting QSBS is covered in Section 1202(h)(2)(A). However, the gifting and trust rules extend far beyond QSBS. When it comes to gifted stock and estate planning, there is a limit before tax implications become involved. The lifetime gift and estate limit are $11.7 million. If the gift exceeds the annually allowed amount by the IRS (which is $15,000), then there would have to be a filed estate and gift tax return.
In 2018, the Treasury Department, under former President Trump’s administration, drafted proposed restrictions to “stacking” (refer to ‘VII. Proposed § 1.643(f)–1: AntiAvoidance Rules for Multiple Trusts’). However, the restrictions were adjusted before being finalized by the Treasury in 2019 due to opposition over the proposed regulations.
A Closer Look at “Packing”
“Packing” refers to a method to increase one’s basis in their QSBS stock in an effort to increase their basis to benefit from the 10x basis exemption limit. Suppose, for example, an investor invested in a company 6 years ago, and then participated in another follow-on round several years later when the company was valued much higher. In the current year, the company IPOs and the investor sell all of their shares – and combine both share purchases to determine their total basis in the issuer.
The utilization of this strategy is to multiply the benefits of the QSBS tax code. This technique is employed to increase an investor’s basis in their stock to utilize the 10x basis maximum exclusion (as opposed to $10M). Unfortunately, these basis elements open the door to manipulation to maximize the exclusion.
Backlash Over the Potential Magnitude of “Packing” and “Stacking”
The NY Times article is accumulating a large number of responses (currently 1,145 and counting). Many of which express some anger over the utilization of QSBS tax breaks outlined in the article.
While the article cites some extreme examples, data on how extensive these practices are is not presented. The Joint Committee on Taxation estimate of the annual tax revenue foregone due to QSBS averages approximately $1.2B in total, including all taxpayers who utilize the QSBS exemption, so the “stacking” and “packing” practices are likely not as rampant among investors as delineated in the article.
Despite the small portion of QSBS claimed in these types of “stacking” and “packing” practices, they may, unfortunately, lead politicians to question the entire tax incentive. Some politicians, such as Senator Casey of Pennsylvania, cite “packing” and “stacking” as their reasoning for supporting the tax code amendment in the proposed BBBA. In a letter sent from Senator Casey’s office, he wrote, “(Section 1202) has been subject to misuse by some.”
While also not a representative sample, the potential magnitude of “packing” and “stacking” QSBS benefits was discussed in an interview on January 3, 2022, between venture capitalist and co-founder of Greycroft, Alan Patricof, and CNBC’s Squawk Box co-anchor, Andrew Ross Sorkin.
Patricof expressed he had never heard of these “stacking” and “packing” techniques in all of his years in the venture capitalist ecosystem. He even went further to investigate. He asked 18 of his portfolio companies if they have ever done or heard of such vocabulary as “stacking.” All stated they have never done this technique and have never really heard of its use within the community.
Also, in the interview, Sorkin asked Patricof:
“The question is whether there should be a tax break effectively for the wealthy to get wealthier? […] The question is should these tax breaks exist at all?”
In which Patricof responded:
“It’s not for the wealthy. This tax break is a benefit to every single founder who takes advantage of qualifying their company. Because you have to hold your stock for 5 year. There are only certain categories that are eligible. It is not just given out to anybody. And it has to be original issue stock. So it is not as widely deployed as you might think.”
Potential Steps to Curtail These Practices
This probing and conflict bring to light some valid questions about what can be done to preserve the integrity and bipartisan benefits of the QSBS tax code.
To date, no reporting by corporations has been required for QSBS. There is a possibility that some of this misuse could potentially be lessened if the IRS mandated the type of reporting noted in Section 1202(d)(1)(C). This reporting stipulates that corporations “…agree to submit such reports to the Secretary and to shareholders as the Secretary may require to carry out the purposes of this section.” The IRS has not required such reporting up to this point.
The Benefits and Future of QSBS
This tax break legislation has bolstered bipartisan support since its beginnings in the early 90s. In extreme cases, the tax code can be exploited and misused. However, the misuse of this tax exemption may not be occurring at a wildly alarming rate. With the proper implementation of restrictions and regulations by the IRS, the benefits of this tax code can continue to be used to contribute to a strong economy and healthy startup marketplace.
As the QSBS tax exemption faces a possible 50% cut in the Senate, join our coalition in effort to protect the economy-boosting aspect of this tax code.
While the proposed BBBA legislation is at a standstill, consider reaching out to your state representatives and senators, voicing your concern and desire to protect our nation’s startup ecosystem.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.
