Clark Armitage Comments on Small Business Stock and Tax Exemption for Capital Gains

Clients who are small business owners or potentially interested in investing in startup stock may want to consider a frequently forgotten tax exemption for millions of dollars in capital gains. 

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The “prototypical” qualified startup stock comes from an entrepreneur who is “building a business out of their garage or a basement, and they built it on credit cards and a shoestring but mostly a shoestring,” said Clark Armitage, a Member in the Washington, D.C., office of tax law firm Caplin & Drysdale. On the other side of the investment, an “angel or family patriarch or matriarch” may decide to use the exemption as part of financing an idea for a longtime trusted employee who “wants to go off to start a business,” Armitage said in an interview.

“That’s a huge exemption,” he said. “$10 million of exempt gain is a great advantage, and that's why people are doing it.”

The break began looking even more attractive to investors after changes to corporate and dividend tax rates in the 2017 Tax Cuts and Jobs Act, Armitage noted. The Tax Reform Act of 1993 brought the exemption into existence, and further amendments over the years expanded it and made the break permanent. Despite the big available savings from qualified small business stock, “To a taxable investor it is a massive, massive opportunity that just nobody knows about,” according to Collin Gutman, a managing partner of SaaS Ventures, which manages a fund that backs enterprise software firms from outside of the major tech markets.

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One caveat for shareholders to keep in mind revolves around whether they’re employees who perform services for the company and may have to make a Section 83(b) election on whether to take or defer income upon the vesting of the stock, Armitage noted. If they expect the value of the stock to grow over time, the shareholder would likely want to take the income upfront so that they can get the tax-exempt capital gains later when they sell the equity shares, he said.

“It's really a little bit of a trap for the unaware,” Armitage said. “For that reason, I find it's really helpful to talk about it.”

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