What to do with the new tax reform as a business owner?
Biden’s new proposed tax reform to increase tax on carried interest can negatively affect institutional investors and small businesses. This will affect small business owners, startups, and projects, in this blog we will discuss what to do as a small business owner. Before diving into this topic, we should understand how private equity works.
What is Private Equity?
Private equity is essential in helping private businesses obtain funding. These firms manage funds to help private companies such as startups expand their working capital, scale operations, make acquisitions, or fund new projects.
In most cases, it is a common and preferred avenue to raise capital or for a business expansion compared to obtaining money thru debt.
The funds they manage can come from Limited Partners, a combination of high-net-worth individuals and institutional organizations.
Private equity firms can manage many types of funding; the most commonly used for startups is Venture Capital.
Venture capital is a fund used for a new business or a matter of expansion. Not all Venture Capital is made equal. Venture capital firms with millions of assets under management will only cut a check for a startup if this raises a series B or higher. These startups are in the growth or maturity stage of their business cycle.
Usually, these investors intend to cash out their investments during an initial public offering or an IPO.
How does Private Equity help startups?
Private equity is different from traditional financial instruments. These companies will provide capital to startups in exchange for the company’s stock. Unlike other financial institutions, obtaining money does not come with high interest and poor repayment plans. Therefore, they make the preferred choice to expand the cash runway for a startup.
In some cases, Venture Capital firms or individual investors will offer their knowledge and expertise to help scale the business. This level of involvement is not usual in traditional financial institutions.
How will the proposed tax reform affect private equity?
The main issue discussed in the tax reform on private equity is the carried interest allocations. In 2018 the allocation increased from 1 year to 3 years, which means investors can only claim capital gain with a favorable tax rate on the carried interest of an investment after three years of holding period. Recently, the government has been looking at extending the allocation to 5 years with a higher tax rate. This issue will impact individual and institutional investors as they won’t be able to take advantage of the much more favorable tax rate on capital gains than the income tax rate.
What does this mean to business owners and investors?
The new tax reform on private equity will directly impact new business and business expansion activities that rely heavily on private funding. Investors might shy away from private equity investment or be looking into liquidating their current holdings to escape the possibility of the allocation extension.
Acquiring debt will be the next option, but the recent increase in the interest rates might make it difficult for a business. Especially if a business is an early-stage startup with no strong credit profile, history, or cash runway.
Merger and acquisition activities might also be affected due to higher interest that needs to be paid to transfer or acquire the other entity.
Funding startups and small business has been one of the biggest use of funds. This new tax reform will affect investors on how they invest and small business in obtaining available funds needed to navigate the economy rising prices in logistics and raw materials to name a few.
What is a possible solution?
There are ways to minimize the Fed tax rate on carried interest allocation so that investors might still consider investing. One way is for new businesses to apply and qualify as small business stock (QSBS) under Section 1202.
This step will allow individual and institutional investors to exclude 100% of their capital gain from the sale or exchange of QSBS if held for more than five years. You can acquire more information thru the Securities of Exchange Commission (SEC) website.
How to qualify as a QSBC
To qualify for as a small business stock (QSBC) there are a few items to check of the list:
- The small business needs to meet and pass the ” qualified trade or business” test. Meaning only small businesses that offer services and products that do not rely on an employee’s skillset to earn revenue. Retail, wholesale, manufacturing, and technology companies meet this test. Firms like professional services in finance, accounting, engineering, hospitality, farming and mining do not pass this test.
- The business has to be a domestic C- Corporation
- The accumulated assets for the small business are less than $50 Million.
How to claim the tax benefit on a QSBC
For an investor to be able to avoid the tax on carried interest, this must:
- The investor needs to be a natural person, meaning not a company
- The investor must hold the stock for five years or more
- The stock is sold thru private placement like private equity
- This stock should be purchased with cash or assets or exchanged for service
How can Investors still benefit from investing in private equity despite the new tax reform?
Investors can waive the carried interest allocation when there is subsequent appreciation in the holding investment. To be able to do this, comes down to the profit-to-cost ratio, whereby waiving the allocation will not impact the total return of the investment.
Institutional investors may narrow their investment into operating partnership businesses or private companies so their income will be less affected by this event.
How are you affected as a consumer?
Consumers have no direct impact from this event; however, due to inflated interest rates and inflation, the spending power might be adversely affected, thus lowering the demand for goods and services. This reform will impact businesses’ sustainment and growth as demand is not meeting the supply. The increase has been seen in the Consumer-Packaged Goods industry, particularly companies whose products are in the cyclical sector.
What can you do to mitigate the risk of losing investors?
At this time, it is vital to seek professional advice and services to maneuver the process in the right and profitable direction for those who are starting a business or planning for an expansion. You can adapt many strategic moves for smooth sailing for business owners and investors.
Time and acquiring the right information are essential elements for a smart business movement.
How can Startup Tandem help?
If Biden passes this new tax reform, funds will be limited to support the growth and initiatives that small businesses take to help the economy, and environment. Venture capital firms greatly fund the innovative startups with surge, angel investors and other PE firms. Without the support of these funds, the United States startup ecosystem will decline. If you have a startup, it is imperative as a startup owner to act fast.
Startup Tandem provides fractional CFO services for startups and small business owners. This service helps small business owners prepare smarter to proactively create forecasting, manage cash, budgets, and financial analysis of their current business financial health and assess to meet growth plans.
Head over to our next blog Financial Management Tips For Early-Stage Startups – Startup Tandem to help you get started with a strong foundation. We are here for anything you may need! Contact Us – Startup Tandem