IV.More Tax Policy — Maintain capital gains tax rates
Founding entrepreneurs and their investors who provide long term equity capital to small businesses as well as employees who participate in a small business’ growth through stock option awards should receive favorable capital gains tax treatment between 5% for individuals in lower tax brackets and 15% for individuals in higher tax brackets.
Maintain existing capital gains tax rates upon expiration
Are proposals to maintain capital gains tax rates at their current levels just another so called “giveaway to the rich?” Beyond the political rhetoric, what should small business owners and their employees know about capital gains tax rates and their impact on the small business community?
As a starting point, Federal income tax rates are graduated and increase as income levels increase. Tax rates for ordinary income (wages, interest and certain dividends) range between 10% to a top tax rate of 35% for top earners.
Different tax rates are generally applied to profits earned on the sale of assets such as securities or collectibles. A “capital gain” is the net profit difference between the purchase price and sale price of an asset. If an individual holds an investment for more than one year, in general, the net profit or “gain” is taxed at a lower “long term capital gains” rate.
In 2003, Congress lowered the long term capital gains tax rate to 15% for individuals in higher tax brackets and 5% for individuals in lower tax brackets. In 2011, these lower tax rates on capital gains will expire and return to the higher 2003 levels.
Why does TakeCommand support lower capital gains tax treatment as an economic boost to the small business community? When individuals including business founders, angel investors, friends and family members write checks to support a company’s growth, there is a high likelihood that their money will not only be tied up for one year but a good five to 10 years.
There is a sacrifice associated with committing long term capital to help entrepreneurs build viable companies. From a practical standpoint, investors can’t draw down the funds for family emergencies and banks rarely accept investments in young, privately held small businesses as collateral for bank loans. Without the financial incentive of receiving a lower tax rate on profits earned from their investments in America’s small business community, investors will be attracted to more liquid investments in publicly-traded large company stocks, bank certificates of deposit or bonds.
For small business employees too
Lower capital gains rates are also important to employees of growth-oriented small businesses. Many small businesses provide employees with the opportunity to participate in the growth of a business through incentive stock option plans. Employees are granted an option to purchase shares of stock in a small business at a set “strike” price. On average, employees are given 5 to 10 years to “exercise” the option by purchasing shares of the company’s stock. Hopefully, the per share value of the company’s stock will increase over time well above the employee’s strike price, providing a profitable gain to the employee.
When an employee decides to exercise the incentive stock option, no ordinary income tax is due based on the difference between the fair market value of the shares on the date of exercise and the employee’s strike price. Notwithstanding potential issues related to the Alternative Minimum Tax, if the employee then holds the shares of stock for more than one year after the date of exercise and more than two years after the date the stock options were granted to the employee, then the employee qualifies to pay the lower capital gains tax rate on realized profits. The employee’s tax savings can be substantial.
Qualifying Small Business Tax Exclusion
There is another issue related to capital gains that can influence small business investment activity. Under current law, individuals may receive a 50% exclusion for the gain from the sale of certain small business stock that is held more than five years.
The amount of the gain that is eligible for the exclusion is limited to the greater of 10 times the taxpayer’s basis in the stock or a $10 million gain from stock in that small business corporation (domestic “C” corporations with gross assets less than $50 million.)
The non-excluded portion of the gain is taxed at the lessor of ordinary income tax rates or 28%, instead of the lower capital gains tax treatment for individuals noted above. The Internal Revenue Code also places some additional criteria for individuals who qualify for Alternative Minimum Tax treatment. With the 50% exclusion, the effective tax rate for individuals who earn capital gains from the sale of small business stock is approximately 14%.
TakeCommand supports the American Recovery and Reinvestment Act of 2009 proposal to increase the exclusion to 75% on the gain from the sale of certain small business stock that is held more than five years to help overcome the added uncertainties and risks associated with providing long term capital to small businesses. The requirement to invest funds for more than 5 years, not just one year to earn standard capital gains treatment, certainly justifies a lower effective tax rate on profits of approximately 7%.
Global Competition for Funding
It is important to note that America’s entrepreneurs are increasingly competing against entrepreneurs in other nations for startup and expansion financing. Entrepreneurial capital is flowing to India, China and other nations where the costs of building new technologies and new businesses are lower than in the U.S. And the tax rates in these advancing nations are lower than in the U.S. too. For example, there are no capital gains taxes in Hong Kong.
It is in America’s best interest to keep individual and venture capital fund dollars on shore to help advance new technologies and businesses. U.S. tax policies should reflect this objective.
