Atlas Yawned: Small biz investment tax cut is too little too short

President Obama is poised to eliminate capital gains taxes on small business investment. Unfortunately, it won't have much impact beyond mom and pop.

During last year's State of the Union Address, President Obama said:  "Let's also eliminate all capital gains taxes on small business investment."

That directive eventually worked its way into the small business tax bill, which is expected to become law within weeks.

On its surface, this should be a boon for startups and the venture capitalists who love them. Moreover, some people have wondered if the move amounts to a VC industry stimulus, since institutional investors might see arbitrage opportunities in a tax-less asset class.

It isn't. And it doesn't.

Instead, the expanded exclusion is a house built upon a foundation of swiss cheese called Section 1202. This deceptive tax provision was introduced seventeen years ago, to eliminate 50% of capital gains taxes derived from qualified small business investment.

To qualify, a company must have a net value of $50 million or less at the time of investment, and the shares must be held for at least five years. Sounds reasonable, but there's more.

Included in that $50 million can be the value of contributed property. For example, how much were Mark Zuckerberg's original codes worth at the time of Facebook's founding? Seems like the answer falls somewhere between nothing (no real company yet) and a few billion dollars (those codes served as the basis for an empire).

OK, so let's assume that a VC fund's investment still meets the aforementioned qualifications. Then, five years later, the issuer raises $200 million in an IPO. At this point, something called the "active business requirement" kicks in. It basically means that the issuer must use at least 80% of its assets (broadly defined) for what amounts to working capital. That's fine if you're a startup that just raised a few hundred thousand, but it's unlikely that $160 million of the IPO proceeds will immediately have a purpose. Some might well be for future (i.e., undefined) acquisitions, for example.

In this case, the original investment qualification is negated, and the VC fund would be required to pay full capital gains rates. It's almost as if the requirement is designed to reward moderate success, but not a blockbuster. Talk about a skewed alignment of interests: "Ummm, I know the banks are telling you that the public markets will buy $75 million of stock at $25 per share, but we'd prefer you to sell at $20 per share."

Even if the active business requirement were stripped from the final bill, there are other reasons for why this tax break is better on the stump than in reality. For example, the exemption increase to 100% is only applicable to investments made during the remainder of 2010. If you do a qualified deal on January 2, no dice.

Another issue is that Section 2010 only applies to non-corporate investors. Partners in a VC fund may qualify, but they'd be knocked out if Congress also follows through on its threat to change the tax treatment of carried interest from capital gains to ordinary income. Moreover, this qualification would exclude banks, insurance companies and most other limited partners that aren't already tax-exempt (public pensions, endowments, etc). As such, this bill would do virtually nothing to increase institutional investor interest in venture capital.

The only place this expanded exclusion would help are on the margins. Individual investment in your uncle's plumbing shop would likely qualify. So might some angel investments in tech startups that sell for short money (maybe some super-angels will voluntarily fall back to earth).

In general, however, Obama is only living up to the letter of his pledge. Not to its spirit.