In the months since President Biden announced his tax reform proposal that included a tax hike on income recognized from capital gains, investors have been keeping a close eye on the political climate and the likelihood that this change would be enacted. Currently, there are only 3 federal tax rates on capital gain income which are simply 0%, 15%, or 20%; overall, favorable in comparison to income tax rates especially for taxpayers who find themselves in that highest tax bracket.
What Changes Could Be Coming?
The proposed budget would increase the taxes on capital gains for Americans earning more than $1 million to 43.4% which makes the rate the same as these individual’s regular income tax rate, completely eliminating the tax benefits of capital gains. This change has and could cause more disruption and volatility to the market as shareholders panic and quickly sell to avoid the changing law.
However, the question of a retroactive increase is now looming over investors’ heads and removing any comfort of actionable avoidance to the new rates. As written, if the proposal passes then any sales occurring after April 28, 2021 will be affected by the new rates. While there is the possibility that the budget doesn’t pass and the even higher possibility that it won’t pass as is, investors still may feel paralyzed.
Many have called into question whether the act of retroactive taxation is constitutional and this will surely be argued before any such budget is passed. Although the following quote from the annotated 5th Amendment of the US Constitution gives little hope to those wishing for an ‘unconstitutional’ ruling,
“Taxation is neither a penalty imposed on the taxpayer nor a liability which he assumes by contract. It is but a way of apportioning the cost of government among those who in some measure are privileged to enjoy its benefits and must bear its burdens. Since no citizen enjoys immunity from that burden, its retroactive imposition does not necessarily infringe due process, and to challenge the present tax it is not enough to point out that the taxable event, the receipt of income, antedated the statute.”
Luckily, there is a section of the IRC which has historically been protected in spite of tax increases.
Section 1202 of the Internal Revenue Code outlines a type of stock specified as Qualified Small Business Stock. Since 1993, investors in Qualified Small Businesses have been able to exclude 50% of their capital gain from federal taxes. This percentage was bumped up to 75% in 2009 and then 100% in 2010. The purpose of the tax exemption is to promote investment in small, innovative businesses that are scalable and would ultimately create more American jobs.
What Else Should Investors Be Concerned About?
While the original proposal made back in the spring included language that would protect this incentive, QSBS is on the list of areas where more taxes could be collected in order to pay for the $3.5 trillion Build Back Better Act. The amendment has started within the House with recent markups done by the House Means and Ways Committee being added to the proposed Build Back Better Act. The Act would change the allowable percent of capital gains that could be excluded from federal tax under Section 1202 from 100% to 50% for taxpayers who recognized $400K in annual adjusted gross income.
By our calculations, the QSBS revenue that could be collected if this amendment were passed could only account for 1.2% of the total cost of the bill and could have detrimental effects on the innovative ecosystem as we know it.
QSBS Expert is Following Closely
We will be following this amendment closely as it makes its way through the legislative process. Join us here if you would like to be kept up to date on any noteworthy changes as they apply to IRC Section 1202.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.