Have you noticed a trend in going public?

It used to be that firms would go public in the first few years of their existence.  Now, they go public after 5, 6, 10 years of existence.  There’s a reason for that.

QSBS.

Qualified Small Business Stock.  This is a provision of the tax code  (Internal Revenue Code, IRC, Section 1202) that dates back to 1993, that became law under the Clinton Administration.  (Back then, only half the gain was protected from capital gains taxes, with the rest subject to higher than normal tax rates.)   It got a WHOLE lot more lucrative in the last five years or so.

The QSBS applies to C corporations (ones that pay their own income tax, not pass-through entities), whose gross assets- the original costs- do not exceed $ 50 million on or after its stock goes public.  Gross assets is NOT the same as market valuation- this is an accounting measure.

Oh- and those firms in the hospitality (hotels, etc.), personal services, financial sectors, farms, and mines need not apply.  (This  IRS section only works for those in tech, retail, wholesale, and manufacturing sectors of our economy- or at least 80% of the assets must be so involved.)

In addition, for this provision to apply, the investor can’t be a corporation (flow-throughs are perfect, though) and the investor had to purchase the (private) stock directly from the firm (not via the  secondary markets) with cash or property (or, a law firm [that operates as a pass-through] that accepted the stock payment for the service provided), and held the stock for at least five years.

I know, you are wondering why- if this provision dates all the way back to 1993- that it’s only know rearing its ugly head?  Because Congress has been tinkering with this section over the past four or five revisions of the tax codes.

Remember that PATH Act (Protecting Americans from Tax Hikes, 2015)?  That’s when investors could consider sheltering ALL of their capital gains from the sale of QSBS.  The cap then was $ 10 million (or 10 times the adjusted basis of the stock, whichever was greater).  Anything that exceeded that valuation was subject to the 28% capital gains tax.  And, was already not subject to alternative minimum tax.  (You know- the tax was developed to make sure that the rich always paid some tax, but in reality it forced the middle class taxpayers to pay more in taxes.)  Up until the latest tax cut, this tax cut provision shorted the US Treasury by $ 1.3 billion a year.

It meant if one invested $ 10 million in the first round of a tech firm startup (when it was worth bupkis)- and held the stock for 5 years- then it’s not just the $ 10 million that gets sheltered, but the 10X the initial investment or $ 100 million is protected  from capital gains taxes.

So, which companies benefit under this tax code section?  Let’s consider UBER, one of the firms that just went public.  Back in 2009 (UberCab), when it was selling stock in the firm, it was basically worthless.  It took another 4 years (until 2013) for it to reach the cap.  And, that exempted some 425 million shares- with a current valuation of some $ 20 billion or so- to incur any capital gains taxes, under this provision of the tax code.

Other venture capital firms have extended their stock sales over several years.  Extending the benefits even further.  Still more rolled the gains from one QSBS qualified firm into another one.

(This provision works for smaller firms, too.  If they are willing to forgo the pass-through concept and incorporate as a C entity- they can sell their stock after 5 years capital gains free.  Because they probably are much small than the cap on asset size that limits the benefits.  A five-year retirement nest egg!)

You can now see why so many of the firms going public have been taking 5 years or more to do so (as opposed to before when going public was the near term, not long-term) goal.   It’s to provide special benefits to the venture capital firms who invested in them

Oh- and given the new tax rates that were approved in 2018 (Tax Cut and Jobs Act), this provision is now being spread way beyond tech.  Because the new law included retail, wholesale, and manufacturing sectors.

You can bet they are salivating over these gains.

Unless the Democrats win the elections in 2020- and will salivate over the more than $ 1.3 billion in potential tax revenue  to deal with infrastructure needs, by repealing this provision.