NVCA Today

The Good and Bad in President Obama’s Budget

President Obama used the roll-out of his budget this year as a platform by which to emphasize the efforts of his Administration on job creation and on programs benefiting the middle-class.  Two areas of importance to the venture industry were included:  changing the taxation of carried interest from capital gains to ordinary income tax rates, and amending the current IRS rules under Section 1202 (Qualified Small Business Stock or QSBS) to allow for a zero capital gains rate for investment into certain qualified small businesses.

Importantly, changes to the tax code outlined in the budget must be enacted separately by Congress.  Since the Administration had launched both proposals last year, their inclusion now is no surprise.  However, with the emphasis in Congress on job creation, amendments to the QSBS rules could finally see the light of day.  A brief discussion of the QSBS rules follows.

QSBS

Congress enacted IRC Section 1202 in 1993 creating a capital gains tax differential between the overall rate and that applied to QSBS.  Unfortunately, a combination of cumbersome Treasury regulations and the application of the Alternative Minimum Tax (AMT) drastically reduced its effectiveness.

For non-corporate taxpayers, Section 1202 excludes from gross income 50 percent (and in the case of investment in empowerment zones, 60 percent) of gain recognized on the sale or exchange of qualified small business (“QSB”) stock held for five years or more. However, there are numerous additional limitations that apply to both issuers and shareholders in order to qualify for this exclusion.  Unfortunately, these limitations have rendered Section 1202 largely inapplicable.

Furthermore, while this exclusion appears advantageous at first blush, it currently offers at most only a one percent tax savings.  Both the Taxpayer Relief Act of 1997 and the Jobs and Growth Tax Reconciliation Act of 2003 lowered capital gains rates generally, without providing for a similar reduction in the rates applicable to Section 1202.  As a result, Section 1202 produces an effective tax rate of 14 percent (i.e., 50 percent of Section 1202 gain is excluded from tax while the remaining 50 percent is taxed at a 28 percent rate), as compared to the 15 percent capital gains rate that applies generally.  In addition, the alternative minimum tax (“AMT”) has further reduced the benefit of Section 1202

Importantly, under the President’s budget proposal the percentage exclusion for qualified small business stock sold by an individual or other non-corporate taxpayer would be increased permanently to 100 percent and the AMT preference item for gain excluded under this provision would be eliminated. As under current law, the stock would have to be held for at least five years and other limitations on the section 1202 exclusion would continue to apply. The proposal would include additional documentation requirements to assure compliance with those limitations.  The proposal would be effective for qualified small business stock acquired after February 17, 2009.

While the President’s proposal is heartening, numerous other challenges to using this code section urgently need to be addressed.  (For a more in-depth review of the QSBS rules, please see the article on NVCA’s web page, written by Proskauer Rose, which originally appeared in the Venture Capital Review.)  Ultimately, however, even if changes are made, it is unlikely that VCs would be able to use the exclusion if the carried interest tax changes are also enacted.

Carried Interest

Current Status:

The House of Representatives passed HR 4213, the tax extender package which uses carried interest as a revenue offset, by a vote of 241 to 181 on December 9, 2009.  The Senate did not act on this legislation before the end of the year, and we believe that the tremendous effort by NVCA members to make their Senators aware of our concerns played a large part in the decision to not rush to implement such a significant change in tax policy.

Because this calendar year continues the legislative session rather than marking the beginning of a new Congress, the Senate can turn to the tax extender package at any point – the legislation does not have to be reintroduced in the House of Representatives.  However, the immediate priority for the Senate, and specifically for Finance Chairman Max Baucus, will continue to be determining whether parts of the health care reform package can be salvaged as well as turning to “job creation” legislation.  While Chairman Baucus and Finance Committee Ranking Member Grassley have indicated that they hope to address the expired tax credits by early February, no one at this point seems to have a clear sense of how or when the extender package will be addressed.

Looking at 2010:

The most immediate danger zone remains the Senate’s consideration of the House-passed tax extender bill.  Although Chairman Baucus has stated that he would rather consider carried interest as part of overall tax reform rather than as a “pay-for” we cannot afford to be complacent, particularly when the continued fiscal restraints under which Congress and the Administration are operating means every potential source of revenue is being discussed.

While completing a broad overhaul of the US tax regime is unlikely in this election year, we fully expect the tax code to be front and center in numerous congressional hearings, both as a response to tax proposals unveiled in the President’s budget and as a means to lay the groundwork for future reform efforts.  Given that, we see 2010 is a critical year for our efforts to help Congress and the Administration understand the integral role the venture industry plays in job creation and why the tax incentive of capital gains is an equally critical part of the venture-entrepreneurial ecosystem.  We’ll be reaching out to the NVCA membership for addition help on this point as we move forward.

SEC Registration – Little Progress in Senate

Although the Senate Banking Committee unveiled its version of financial regulatory reform on November 10, 2009, Chairman Dodd’s approach sparked enough controversy within his committee that the draft legislation has seen little movement since its inception.  In response to criticism, the Chairman created “working groups,” pairing a Democrat and a Republican committee member, in order to address the most contentious segments.  Fortunately, Title IV of the discussion draft which explicitly exempts venture capital fund advisers from both registration requirements as well as from any additional reporting requirements is not among the divisive components.

In recent media appearances, Chairman Dodd has indicated that he expects the Committee to finalize a draft “soon” but he has already missed one self-imposed deadline of the end of January.

Although leaving the definition of venture funds to the SEC could produce further battles down the road, having explicit exemptions in both the House and Senate measures will put pressure on the SEC to effectively carry out Congressional intent to leave the industry unharmed.  The House passed its version of financial regulatory reform on December 11^th.  Despite the current emphasis on job creation legislation, we expect this effort to remain a top congressional and Administration priority.

SBIR Reauthorization Extended Three More Months to April 30, 2010 – Compromise Close?

Last month, the House and Senate passed legislation to extend the deadline to reauthorize the SBIR program until April 30, 2010.  The Senate and House conferees seem to be close to reaching a compromise which potentially could fix the affiliation rules and allow majority venture-backed companies to participate in the SBIR program up to a certain percent of the total available SBIR dollars at specific agencies.  The percentages under discussion are: 25% at NIH, DOE, and NSF and 18% at all other agencies.  When and if the conferees can come to an agreement, Congress should be able to move quickly to finalize the SBIR reauthorization.

“Start-Up Visa” Included in House Comprehensive Immigration Reform Bill

Over 90 members of the House co-sponsored legislation in December for comprehensive immigration reform (the Comprehensive Immigration Reform for America's Security and Prosperity Act of 2009) that could make some broad changes to the H-1B program.  According to the bill’s architect, Rep. Luis Gutierrez (D-IL), the legislation tries to find common ground in addressing the needs of labor unions, businesses interests, as well as the Hispanic community.

A main concern for industry groups is that the bill does not create a temporary guest worker program that addresses the labor needs of high-tech industries.  Instead, the bill would create a system under which 100,000 work visas would be issued to foreigners via a lottery.  The bill does not increase the cap for H-1B work visas, but does call for the release next year of all the unused H-1B visas from 1992-2008 (or around 309,000 visas) according to one source who has seen some details.

Importantly, the legislation also calls for the creation of a new visa, called the "Start-Up Visa,” an idea championed by VCs, and introduced in December by Rep. Jared Polis (D-CO).  Polis’ language would streamline and speed-up the EB-5 visa application process; permanently reauthorize and expand the pilot Regional Center Program in economically disadvantaged areas; and create the “Start-up Visa” for entrepreneurs who have received venture capital investment.  The EB-5 program provides visas to foreign investors or entrepreneurs who invest at least $1 million (or $500,000 in economically disadvantaged areas) and create ten full-time jobs (5 in economically disadvantaged areas).

The legislation would create a new, independent Federal agency, to be called the "Commission on Immigration and Labor Markets," which would establish "employment-based immigration policies that promote economic growth and competitiveness while minimizing job displacement, wage depression and unauthorized employment."  The new agency would also recommend H-1B and other visa caps to Congress.

A competing immigration bill in the U.S. Senate is expected soon, but the timing of that bill is yet undetermined.