Paul L. Caron

Friday, May 26, 2023

Weekly SSRN Tax Article Review And Roundup: Speck Reviews A Critical Evaluation Of The Qualified Small Business Stock Exclusion By Polsky & Yale

This week, Sloan Speck (Colorado; Google Scholar) reviews a new work by 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).


After 2017’s Tax Cuts and Jobs Act, some commentators predicted a renaissance in taxpayers’ use of the statutory exclusion for gain from qualified small business stock under § 1202. In 2015, Congress made permanent the provision’s 100 percent exclusion that emerged in the wake of the Great Recession, and the TCJA’s fourteen-point reduction in corporate rates heralded new benefits to bucking longstanding conventional wisdom that taxpayers should operate nonpublic companies as passthroughs. These predictions didn’t really come to pass, as Polsky and Yale observe in their magisterial exegesis of § 1202, A Critical Evaluation of the Qualified Small Business Stock Exclusion. 

Polsky and Yale elaborate that § 1202 remains niche in its application: “a windfall bestowed on undeserving taxpayers” that is “exceptionally complicated and riddled with loopholes” and, on the whole, “an utter tax policy disaster.” Unsurprisingly, Polsky and Yale advocate repealing § 1202—or, failing that, wholesale reformation of the provision.

Polsky and Yale build their compelling case that § 1202 represents “a trifecta of tax policy failure”—inequitable, inefficient, and anything but simple—through a deep examination of the provision’s mechanics, coupled with nuanced knowledge of business practices, informed commentary about planning techniques, and careful discussion of economic implications. As Polsky and Yale walk through § 1202’s operation and effects, they expose a veritable compendium of tax gaming from the mundane to the aggressive, and they ably lay bare the players, stakes, and incentives (or lack thereof) in fascinating detail. The effect is impressive: the alpha and omega of qualified small business stock.

Critical to Polsky and Yale’s argument is the fact that Main Street businesses (still) tend to operate as partnerships, leaving venture capital—“VC”—as the principal beneficiary of § 1202. The causes of this landscape are, in part, idiosyncratic. Venture capital investors typically prefer startups that operate as corporations for tax purposes. This preference is motivated by good and valid business considerations, including, as Polsky has elucidated elsewhere, subchapter K’s often-overwhelming compliance burden for complex economic arrangements. (Corporate startups also might yield more government revenue, if failed ventures’ losses are trapped at the entity level.) For this reason, Polsky and Yale describe § 1202 as “a de facto subsidy to the VC industry,” rather than a broad-based benefit for small businesses. Moreover, given the historic glut of undeployed capital at VC firms, § 1202—as applied—has “little if any positive incentive effects” in terms of encouraging marginal investment. A small solace: if § 1202 is pernicious, at least it’s also relatively contained.

In some sense, however, VC investors’ choice-of-entity preferences are foisted on founders, who must buy into the system to access capital and financial expertise for their businesses. Founders, of course, ultimately benefit from § 1202, if their startup succeeds. Under current law, this benefit generally is limited to $10 million of excluded gain, subject to gaming, such as the “stacking” techniques discussed by Polsky and Yale. Furthermore, this exclusion—on its face, still generous—merely puts exiting founders in a similar tax position as if they had chosen partnership form from the outset. (The math is detailed by Polsky and Yale at 382–84.) Sure, § 1202 introduces serious uncertainties involving timing and changes in law. But there is a sort of rough justice (or perhaps a spurious allure) to this type of tax parity. Founders, who don’t really have a choice when it comes to choice-of-entity, receive tax treatment as if they were Main Street instead of Silicon Valley. This rationale also lends a veneer (perhaps thin) to planning that enhances the § 1202 exclusion. Under the partnership regime, single-level taxation is complete, and “stacking” moves founders’ exclusion in this direction.

From this perspective, the real villains aren’t founders but the mangers of VC funds. (Polsky and Yale note that angel investors benefit from § 1202 but are “relatively small players in the VC ecosystem.”) Fund managers raise capital from investors, advise startups in their portfolio, and receive a carried interest—perhaps not quite two-and-twenty—for their time and energy. Some or all of this carried interest may qualify for exclusion under § 1202, and VC fund managers are likely repeat players who serially claim the § 1202 exclusion. The distributional consequences are not salutary, especially if § 1202’s incentive effects are minimal. This problem, of course, intersects and overlaps with carried interest reform more generally. To the extent that VC fund managers have compensation income and not capital gain, § 1202 should not matter, and one of the provision’s major infirmities is rendered moot. This potential for positive spillovers perhaps yields a further reason to pursue genuine carried interest reform in earnest.

Finally, through all of Polsky and Yale’s trenchant analysis, § 1202’s value and function depends significantly on a normative baseline that income is, in fact, the thing that should be subject to tax. It is well-traveled that, as an empirical matter, the United States’ income tax system contains substantial consumption elements for a wide array of taxpayers. Polsky and Yale rightly emphasize § 1202’s distributional consequences, as well as the compliance burdens engendered by the provision. Indeed, the more egregious game-playing with respect to § 1202 reeks of the same ethos that allowed Peter Thiel to accumulate billions in a Roth IRA. But in approaching reform, one might frame the question as about which taxpayers should be subject to a consumption base, and to what extent.

Overall, Polsky and Yale give a definitive and comprehensive discussion of § 1202—“a wasteful, misguided subsidy”—from legal, practical, and policy perspectives. Scholars in both taxation and entrepreneurship should find Polsky and Yale’s arguments illuminating, and policymakers would be similarly well-served to study Polsky and Yale’s excellent article.

Here’s the rest of this week’s SSRN Tax Roundup:

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