September 25, 2022

Unitranche

Supportive Business Potential

Like ants, Silicon Valley drawn to tax loophole

My wife hates ants. Intensely.

If an ant is discovered in our kitchen, the day — perhaps even the week — is ruined. Every able-bodied person at the house will be drafted into service against the enemy.

The enemy is both capable and crafty. If one ant finds a food source, it can use pheromones to create a food trail for the rest of the colony.

As long as the food source is active, newly arriving ants continue to refresh the pheromone trail. We have all seen the results of the ant version of Oregon Trail.

Scientists have only started to study the pheromone behaviors of tax attorneys and CPAs. Studies confirm that if one tax adviser discovers a loophole, he or she lays a trail for other advisers.

As long as the loophole remains open, these crafty tax advisers refresh the trail. When conditions are right, the loophole pheromones will even be laid for advisers from different colonies.

Skilled pest control companies can control ant colonies. There does not seem to be a natural enemy of these companies.

Unfortunately, when long lines of tax advisers discover a loophole trail, even skilled government tax authorities face great challenges. A creature known as a “lobbyist” is a natural predator of such officials.

Packs of razor-teethed lobbyists prowl the corridors of government offices. Tax authorities have proven to be little challenge to these fearsome creatures.

Section 1202 of the tax law was enacted in 1993. It was intended to provide a tax break that would encourage investment in certain small businesses.

The tax break first excluded 50% of gains from the sale of small business stock from the tax base. In 2009, it went to 75% and in 2010 to 100%.

The break is limited to $10 million per taxpayer. The break ends when the business has more than $50 million of assets.

The business has to be a “regular” corporation. Also called “C” corporations, these corporations have fallen out of favor in recent times.

About five years ago, I did a presentation at an out-of-state tax conference on this Section 1202 tax break. Most advisers in the audience did not use it. Most advisers in New Mexico do not use it.

The “problem” is that the C corporation form just isn’t very popular. And most “regular” tax advisers just don’t see clients with new business opportunities that could reasonably create a $10 million gain.

It turns out that the pheromones are running heavy in Silicon Valley. New ventures often produce big gains in the Valley.

The gains can be so big that $10 million just isn’t attractive enough. Tax advisers figured out that the lobbyists created a special multiplier of this break.

Recall that the limit for the exclusion is $10 million per taxpayer, not per company. The law allows stock to be gifted with the recipient also eligible for the tax break.

The Silicon Valley tax advisers tell their clients to “stack” the benefit by gifting shares to family members before a sale. Articles quote these advisers as suggesting that “everyone” is stacking.

If everyone is doing it, we can be assured that tax-saving pheromones are being laid down throughout the Silicon Valley. An army of pesty tax advisers is sure to follow until the food source is extinguished.

I believe there is a sound tax policy for the small business tax break. I could expand but I’d prefer to use this space to say there is no policy reason to allow the break to be stacked by gifts.

I also believe, from many personal experiences, that there are many very intelligent, very creative tax advisers in the country. You really have to admire some tax-saving ideas that work.

There is no intelligence or creativity required to stack the small business tax break. The law itself says the stock can be gifted and pass on the benefit.

Stacking requires only a founder who is rich enough to pass on tens of millions of dollars to family. Turns out there are lots of them.

Lobbyists convinced Congress to leave a complete chocolate cake on the kitchen floor. Of course an ant found it. And of course the pheromone trail smells strong.

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at [email protected]