Startup companies and their investors can breathe a little easier. The tax reform bill working its way through the legislative process is likely to include provisions that, if passed into law, could help early stage companies.
In November 2017 the House passed its tax reform bill, H.R. 1 – also known as the Tax Cuts and Jobs Act. It received significant media attention for, among other things, lowering the corporate tax rate to 20%. This stands to benefit for-profit corporations of all sizes.
Yet to members of the startup community, the bill shows something perhaps even more interesting – a focus on promoting innovation and entrepreneurship. New companies often do not have revenues, and their investors take significant risks. Because of these characteristics, these companies arguably deserve tax treatment that is different from that of established businesses.
House Majority Leader Kevin McCarthy, along with the vast majority of his fellow House Republicans, supported the bill. He said in a November 1 Financial Times piece that “we need a dynamic tax code that promotes the competition, risk-taking and innovation that is the foundation of the 21st-century economy.”
Some specific parts of the bill that would benefit startups:
- The bill preserves the gain exclusion for sale or disposition of “qualified small business stock” (Section 1202 of the Internal Revenue Code), which encourages people to invest in early stage companies. The U.S. Senate has passed its own version of the bill, which likewise preserves such exclusion for gains on qualified small business stock.
- The bill preserves the research and development tax credit (R&D Tax Credit), although a conflict with the corporate Alternative Minimum Tax provisions in the Senate’s bill will need to be addressed.
- The R&D Tax Credit lets a company redirect money from federal taxes to fund research and development expenditures (including salaries, supplies, contract research, and computer leasing).
- It is important to many new and high-growth companies, as well as more established companies.
- The bill includes provisions making it easier for early stage companies to attract new employees with incentive equity and other deferred compensation.
- Currently, startups often offer restricted stock units or stock options instead of cash compensation to employees and other contractors. When the restricted stock units vest or when nonqualified stock options are exercised, for example, the holder is sometimes liable for taxes, even if the stock can’t be sold to pay the taxes. This reduces the utility of incentive equity.
- The House bill would defer tax payment until the equity can be sold, or would provide an extended timeframe in which to pay the tax bill.
- Enhancing the attractiveness of incentive equity would help startups compete against established companies in attracting workers.
- By contrast, the Senate bill includes different and harsher provisions regarding such forms of compensation.
Negotiators from the House and Senate are now working on a final version of a tax bill. Stay tuned to see what comes out of the House and Senate efforts to reconcile the two bills.