Polsky & Yale: A Critical Evaluation Of The Qualified Small Business Stock Exclusion

Gregg D. Polsky (Georgia; Google Scholar) & Ethan Yale (Virginia; Google Scholar), A Critical Evaluation of the Qualified Small Business Stock Exclusion, 42 Va. Tax Rev. 353 (2023):

Section 1202 of the Internal Revenue Code grants a gain exclusion to certain shareholders who own "qualified small business stock." We describe the tortured history of this rule, explain how it works (and fails to work), and critically evaluate whether the rule serves any coherent policy objective. If Congress keeps the rule in place, significant revisions are necessary to align the rule with sound policy and tamp out the abusive manipulations arguably permitted by the law in its present form. We propose several improvements along these lines. We also make the case for eliminating the exclusion in its entirety.

Conclusion
Section 1202 should be repealed or at a minimum significantly reconfigured. As it stands now, the provision operates as a de facto narrowly targeted tax break to the venture capital industry, which is already flush— and many would say far too flush—with capital. Accordingly, section 1202 has little if any positive incentive effects. Instead, it is a pure windfall to founders of successful start-ups, to angel investors who have invested in these companies, and to general partners of venture capital firms. The latter group often receive the largesse of section 1202 many times over, through the carried interest they receive on a fund-wide basis. All of these beneficiaries are, to put it mildly, not in need of any government largesse.

Section 1202 is also ridden with egregious loopholes. Stacking strategies allow beneficiaries to multiply the statutory cap through gifts, and aggressive tax advisors argue that stacking through trusts can effectively grow the cap to infinity. No reasonable person can argue that these maneuvers are consistent with the intent of Congress, which presumably included the cap in section 1202 for a reason.

Finally, section 1202 is a compliance nightmare. The technical details are numerous and intricate. Satisfaction of the gross assets test is extremely difficult for a small business to establish, particularly well after the fact, which is when the exclusion will actually be claimed.

Section 1202 therefore qualifies as a trifecta of tax policy failure—it is inefficient, unfair, and complex. The only thing it has going for it is that it sounds like something useful. Who doesn’t like to support entrepreneurship and small businesses? But, as this Article has shown, section 1202 is nothing like what it appears to be.