With a new administration comes new perspectives and likely changes in tax policy. President Biden has proposed doubling the rate that wealthy Americans pay on investment capital gains up to 43.4%, a topic that has been widely written about (e.g., see these articles:(1),(2)). Some people fear that the proposed tax structure changes will hurt the returns on private investment into venture capital and private equity funds. These funding sources have been a primary source of funding for life science innovation, the continued need for which has never been clearer. Indeed, it was private investment that laid the foundation for the enormously successful mRNA vaccines crucial to addressing the pandemic (3).
Fortunately, certain tax incentives for investors remain in place. Investors have an opportunity to place investments into early-stage life science companies with no associated federal capital gains taxes. Specifically, sections 1202 and 1045 of the Internal Revenue Code (IRC) provide a powerful tax incentive to invest in early-stage companies, resulting in an enhanced effective return opportunity for investors. It’s good for investors and for our nation as a whole, helping facilitate investment into the type of high-impact life science companies that drive innovation. Although IRC 1202 and 1045 are not limited to life science investment opportunities, the benefits of the provided capital gains exclusion is especially significant in these types of high-reward investments.
IRC Section 1202 can provide 100% gains exclusion on qualified small business stock (QSBS). A Qualified Small Business (QSB) is an active domestic C corporation whose gross assets do not exceed $50m at the time of its stock issuance (including capital raised in the issuance). To be eligible for the exclusion, the investor must hold the investment for at least five years. There is also a limit on the exclusion of 10x basis or $10m, whichever is greater.
Let’s look at one possible scenario:
Investor A places a $100,000 investment at $1/share into a young, high-growth opportunity C-corp (“YoungCo”) that has less than $50m in assets at the time of investment.
Investor B places a $2m investment into YoungCo at the same time.
Five years later YoungCo sells for a sum that works out to $7/share for all investors.
Investor A receives $700,000 i.e., a $600,000 gain from their original investment. That is both less than the 10x basis limit and less than the $10m total limit. Thus, Investor A receives 100% exclusion of the gain i.e., their investment return is tax free at the federal level.
Investor B receives $14m i.e., a $12m gain from their original investment. That is more than the $10m total limit for IRC 1202. However, it is less than 10x basis (i.e., 10 x $2m). Thus, Investor B also receives a 100% exclusion of the gain under federal tax law.
The scenario above worked out great for the hypothetical investors. But what about investments held less than five years? For example, assume YoungCo receives and accepts an excellent buyout offer three years after Investors A and B place their investments rather than five years as in the example above. For this modified scenario, IRC Section 1045 can be taken advantage of. IRC 1045 complements IRC 1202; it allows taxpayers who haven’t achieved a five-year holding period for their QSBS to roll otherwise taxable gain on the sale of their QSBS on a tax-deferred basis into replacement QSBS. Thus, if the investors roll over any portion of their investment into another QSB, and hold that investment at least another two years (i.e., at least five years total from the time they acquired stock in YoungCo), then whatever portion of their original investment that they rolled-over would be eligible for the IRC 1202 capital gains exclusion.
A key limitation of IRC 1045 is that the new investment must be made within a 60-day window. This is an important limitation as two months is not much time to conduct due diligence and close an early-stage investment. For instance, in a typical angel investor network, the quality of the deal flow varies considerably, it’s often hard to identify a qualified person or team willing to lead the due diligence, and turn-around time is rarely 60 days. In contrast, this is not a significant issue for members of the VIC Investor Network (VIN). VIN members see new QSB investment opportunities on a monthly basis. Every investment opportunity presented to VIN members has been thoroughly vetted prior to presentation. These high-upside life science investments typically close within 30 days of the offering to VIN members.
IRC 1202 and 1045 can protect the upside for investors in early-stage companies by reducing or eliminating federal capital gains taxes. They provide significant incentives for investing in companies at earlier stages. The IRC 1202 and 1045 make both economic sense (i.e., they are examples of a good government incentive program) and good investor sense (i.e., investors should consider putting some portion of their investments into the type of companies that can take advantage of IRC 1202 and 1045).
In addition to protecting the upside such as described above, there are ways to mitigate the risks of early-stage investments as was discussed in my article last month (4). For investors in certain areas where there are strong state incentives for targeted investments, the downside (i.e., loss of investment) can also be protected. My article next month will discuss some of the advantages of investing outside the traditional venture capital hot spots including the type of state incentives that can limit the downside risk while preserving the high upside opportunity.