Skip to main content

Budgetary Effects of Modifying the Qualified Small Business Stock Exclusion

Introduction

As discussions around the expiration of the Tax Cuts and Jobs Acts (TCJA) increase, conversations around potential “pay-fors” have picked up. A simple extension of the TCJA for ten years would cost about $4 trillion over ten years, excluding interest costs – a number which does not take into account any new or additional tax policy that policymakers would want to implement.

Any pay-fors should be evaluated on their efficacy as a policy instrument as well as the revenue raised. Over the next few months, the Budget Lab plans on taking a look at a few possible pay-fors that policymakers may be considering. In this work, we examine the section 1202 exemption for sale of small business stock as a policy lever and for its revenue potential. 

Background

Initially enacted as part of the Omnibus Reconciliation Section Act of 1993, section 1202 of the Internal Revenue Code (IRC) allows capital gains earned from certain “small business” stock to be excluded from tax. It was established to encourage investment in small businesses.  The provision aimed to encourage investment in small business by creating a tax incentive for capital invested in small businesses and, subsequently, to help small businesses overcome uncertainty and difficulty with obtaining funding. The idea was that this funding would lead to more entrepreneurship, job creation, and innovation through a lower cost of capital for these businesses. Whether these new businesses and jobs are merely the replacement of old jobs and reallocation of capital from old/larger firms is an empirical question.

The provision allows up to 100% of gains from the sale of stock attributable to qualified businesses to be excluded from federal tax. To be eligible, businesses must meet certain criteria. They must be organized as a C-corporation, have less than $50 million in gross assets at time of stock purchase, and operate in a qualified trade or business.1 Additionally, the stock must be issued directly by the company and be held for a minimum of 5 years. Stock issued after 1993 receive a 50% exclusion while those issued after 2010 receive a 100% exclusion. Furthermore, exclusions are limited to the greater of $10 million or 10 times the taxpayer’s basis.

Impact of Policy

There is a lack of empirical evidence on this policy. There is little work on the effectiveness of this policy in terms of job creation, increasing funding for small businesses, or the increase in longevity of those small businesses. Some of that difficulty is related to the availability of the data for researchers.2 What little research there is suggests that the price of stocks for eligible firms was higher after enactment. The higher price reflects the tax benefit associated with the stock. As such, the limited evidence suggests that the benefit is captured by the issuing corporation (aka “initial investors”) rather than new investors.3 This result is evidence that the entrepreneurs face a lower cost of capital as a result of this policy.

However, the provision requirements may poorly identify start-ups and new businesses. The requirement that the small business is organized as a C-corporation implies that most start-ups will not benefit from this provision. The Department of Treasury’s Office of Tax Analysis (OTA) developed a methodology that identifies small businesses from tax returns.4 The methodology reports that, in 2014, only just over 5% of small businesses organize as C-corporations while over 89% organize as pass-throughs. However, C-corporations may be disproportionately likely to yield large capital gains.

In addition, the requirement that the corporation must have less than $50 million in gross assets allows firms that are quite large to take advantage of this tax benefit. While the OTA methodology does not utilize assets as a condition, it is not likely that many of the firms meeting the OTA income or deduction limit of $10 million would have assets near $50 million. 

Potential Policy Options

Recently, H.R. 3937 (the “Small Business Jobs Act”) offered modifications to the exclusion provision that would have expanded the type of firms that qualify for the exclusion and reduced the holding period.  Here we present the budget effect of this modification as well as a modification that moves in the opposite direction. Additionally, we present the budget effect of eliminating the exclusion.

Option to Expand 1202: H.R. 3937

H.R. 3937 expands section 1202 exclusion by introducing a phase in of the exclusion. Currently, stock must be held for five years to receive 100% exclusion. This bill allows for a 50% exclusion for stock held for three years and a 75% exclusion for stock held for four years. It also expands the coverage by allowing stock issued by S corporations rather than just C corporations. This option loses almost $15 billion over the 10-year budget window (2026-2035).

Option to Raise Revenue

As an alternative to H.R. 3937, we considered an option that increased the holding period for the qualified small business stock. This option requires a seven year holding period for the full 100% exclusion. If a stock is held five years, it receives a 50% exclusion while holding stock for six years receives a 75% exclusion. In this option there is no modification to the requirement that the issuing firm needs to be organized as a C corporation. Over the 10-year budget window, this option raises about $8.5 billion. 

Elimination

This option disallows any exclusion of gains for qualified small business stock. This option raises just over $81 billion. Table 1 presents the year by year estimates of these options.

Footnotes

  1. A qualified trade or business is any trade or business other than those involving personal services, banking, insurance, financing, leasing, investing, or similar activities, farming, natural resource extraction, and business operating hotels, motels, restaurants, or similar businesses.
  2. Recent work by Office of Tax Analysis economists presents the data and illustrates the difficulty in using the data. Slides from National Tax Association Conference “The 100% Exclusion of Capital Gains on Small Business Stock” presented by Gerald Auten.
  3. Guenther, David A. and Michael Willenborg, “Capital gains tax rates and the cost of capital for small business: evidence from the IPO market”, Journal of Financial Economics, Volume 53, Issue 3, 1999, Pages 385-408.
  4. Richard Prisinzano, Jason DeBacker, John Kitchen, Matthew Knittel, Susan Nelson, and James Pearce. “Methodology to Identify Small Businesses and Their Owners.” Office of Tax Analysis Technical Paper 4 (update), November 2016.