The Qualified Small Business Stock Exclusion: How Startup Shareholders Get $10 Million (Or More) Tax-Free

Abstract

The IPO parade of 2019 is making the early shareholders of technology startups such as Uber, Lyft, Slack, and Pinterest (among others) staggeringly wealthy. Now that these companies are publicly traded, equity owners can cash out at a huge profit. This profit would normally be taxed at long-term capital gains rates. But the qualified small business stock exclusion of Section 1202 of the Internal Revenue Code, a provision whose ostensible purpose is to promote investment in small businesses, will result in many of these millionaires paying zero federal taxes on much of this sudden wealth. This Essay demonstrates that the loss in federal tax revenue due to Section 1202 is far greater than previously estimated, with the provision almost exclusively benefitting the wealthy. Section 1202 represents flawed tax policy in that even if catalyzing investment in small businesses is normatively desirable, the provision does little to promote that result. Though putatively applicable to investors in “small businesses,” most truly small businesses are precluded from using Section 1202. Instead, this Essay shows that tech startups with valuations in the billions are common beneficiaries, and suggests how both federal and state actors could mitigate the provision’s effects.