Monday, September 27, 2010
Founders of a start-up usually take common stock as a large portion of their compensation for current and future labor efforts. Getting paid in founders’ stock allows entrepreneurs to defer paying tax and—more importantly—allows them to pay tax at the long-term capital gains rate. Politicians, entrepreneurs, and many academics claim that the favorable tax treatment of founders’ stock is an effective method of subsidizing entrepreneurship.
This Article questions the widely-held view that we should tax founders’ stock at a low rate. The economic efficiency case for a tax preference for founders’ stock is weak. Tax policy is an ineffective policy instrument for subsidizing entrepreneurship; tax has an effect on entrepreneurial entry, but the effect is small. Tax is less important than geographic, cultural, and business factors. And tax is less important than other elements of the legal infrastructure, such as immigration policy, employment law, and securities law.
The case for reform is compelling. Taxing founders at a low rate is a conspicuous loophole in the fabric of our progressive income tax system, uniquely undermining our commitment to equal opportunity and distributive justice. Founders’ stock is often bequeathed to heirs who receive a step up in basis, allowing founders to avoid the income tax altogether, leaving a legacy of dynastic wealth subject only to the rather dodgy application of the estate tax.
While it would be desirable to eliminate the tax subsidy and instead tax gains from founders’ stock as labor income, fixing the problem is not easy. I offer a range of possible solutions that policymakers might consider.