A decade ago, when Washington was still buzzing with that “hopey-changey” spirit unleashed by former US President Barack Obama, the White House became excited about angels.
In 2010, it unveiled a policy reform known as the “Qualified Small Business Stock” framework, that promised to shield seed (or “angel”) investors from capital gains tax if they funded businesses with less than $50m assets for at least five years — up to a maximum value of $10m. The idea behind this initiative (which expanded an earlier, very modest QSBS tax break) was to “increase private sector investment in small business” and encourage innovation, or so the announcement went.
It was, if you like, the tax equivalent of Motherhood and Apple Pie — something designed to get bipartisan Congressional support, which duly happened.
Fast forward a decade, however, and those angels are no longer flying so high. In the coming days, Democrats will present the $1.75tn Build Back Better infrastructure bill to the Senate, after it passed a House vote. And tucked (very) deep inside the behemoth is a clause that would reverse Obama’s QSBS reforms.
Thus far, few outside the angel world have noticed. But investors of all stripes should take note. For this is a powerful symbol of how President Joe Biden’s bold aspirations are becoming badly tarnished as “hope” collides with the “sausage-making” process that is Congressional policymaking.
The issue at stake revolves around America’s stark disparity between tax rates on capital gains and incomes. The Biden team has repeatedly expressed a desire to create a more equitable tax culture, saying they want to plug the national fiscal hole by curbing the ability of savvy financiers to cut their tax bills by qualifying income as capital gains.
Thus when they drew up the BBB bill, the administration took aim at the carried interest framework that has been used for decades by private equity and real estate funds among others. “[Carried interest] is a loophole that absolutely should be closed,” Jared Bernstein, senior economic adviser to the White House, observed in September.
However, the team also introduced a clause that would slash the headline QSBS tax break from 100 per cent to 50 per cent (or 30 per cent in effective terms, once other tax reforms are taken into account). This follows reports that some of the angel investors that have benefited from QSBS in the past decade are the ultra-wealthy of Silicon Valley.
Personally, I have considerable sympathy for the instincts driving this White House mission. As the legendary investor Warren Buffett famously observed, it seems perverse that financiers like him have been able to organise their affairs to pay lower effective tax rates than a secretary by classifying earnings as capital gains. It makes sense to have incentives to back entrepreneurial risk taking, but not with this level of arbitrage.
But even if Biden’s mission seems laudable, the execution is not. The first draft of the BBB bill attacked the carried interest “loophole”, as Bernstein wanted. But this was subsequently watered down in the face of intense lobbying by the private equity industry and others. Or as Bernstein lamented, also on CNBC: “When you go up to Capitol Hill and you start negotiating on taxes, there are more lobbyists in this town on taxes than there are members of Congress.”
The QSBS reforms, however, have remained in the bill, even as the carried interest ones have been mostly scrapped — presumably because small-time entrepreneurs have less clout than Wall Street giants. To add insult to injury, the new regime would be retroactively imposed on existing investments — never mind the fact that many investors have made five-year commitments in the past decade, based on the Obama tax shelter pledge.
Unsurprisingly, the angel investing industry is furious — and has warned these moves would curb capital flows to entrepreneurs. After all, it notes, just 4.1 per cent of all venture funding currently goes to seed finance, a proportion that has fallen in recent years relative to the tsunami of money moving into late stage funding.
Such predictions of doom are probably overstated, given how much newly-created wealth is now swirling around places such as Silicon Valley, looking for an investment home. But, if nothing else, the capricious, retroactive nature of the reforms is likely to (further) undermine investor trust in US tax structures or the consistency of future Washington policymaking.
What makes the situation doubly perverse is that the proposed tax take from this reform is a mere $5.7bn over a decade, according to the Congressional Joint Committee on Taxation. That is chump change compared to the size of America’s fiscal hole (by way of comparison the proposed inheritance tax reforms would raise more than $200bn.)
So will the attack on angels actually happen? Right now, nobody knows, given that senators will almost certainly change the BBB bill if they actually pass it (which remains a big “if”). But what is already crystal clear is that this sorry tale has exposed the grubby nature of the Washington lobbying machine — sapping the hope that Biden can produce a sensible policy plan. Sometimes angels can be truly symbolic.