SENATE COMMITTEE ON SMALL BUSINESS & ENTREPRENEURSHIP

Roundtable on

Unleashing the Power of Entrepreneurship:
Stimulating Investment in America's Small Businesses
May 22, 2002

Written Comments of Mark G. Heesen, President
National Venture Capital Association

Introduction/Summary:
Access to adequate capital resources has been and will continue to be the key enabler to the success of our country's entrepreneurial small businesses. These firms add vibrancy, innovation and growth to our economy. Venture-backed companies, in particular, have demonstrated a remarkable ability to leverage the equity capital resources and guidance they receive from venture capitalists to generate high levels of job growth and revenues. Investments by venture capitalists over the past 30 years have built companies that are responsible for nearly 11 percent of the U.S. gross domestic product, have created 12.5 million jobs and have generated $1.1 trillion in revenue in the year 2000 alone. Assuring that this model of economic growth continues and thrives should be a priority.

As president of the National Venture Capital Association, I am pleased and honored to participate in this roundtable program. This discussion comes at a critical time since history has shown that small, entrepreneurial firms are the companies that most efficiently and aggressively add jobs to the economy during an economic downturn, thereby helping to restore growth.

The Committee is to be commended for having identified three important areas for discussion: barriers to capital formation; tax considerations; and legislative proposals to stimulate small business investment. NVCA has been focused on three long-standing tax considerations that continue to pose barriers to capital formation as well as an immediate concern posed by an IRS proposal regarding the tax treatment of statutory stock options. Specifically, these issues are:

• the erosion of beneficial tax treatment of gains on the disposition of 'qualified small business stock' (QSBS) under section 1202 of the Internal Revenue Code (IRC);
  
• problems associated with IRC section 1045, regarding how the capital gains 'rollover' provisions of that section apply when a partnership disposes of QSBS and reinvests the proceeds in other qualified small businesses;
  
• difficulties posed to entrepreneurs by the individual Alternative Minimum Tax; and
  
• the threat to the use of qualified stock options, including Incentive Stock Options, posed by a current IRS proposal that would mandate the imposition of withholding taxes on the exercise of these options.

Importantly, legislation introduced last year by Chairman Kerry and Senator Max Cleland (The Affordable Small Business Stimulus Act of 2002, S. 1676) would do much to restore the effectiveness of IRC section 1202 as a capital formation tool and would enhance the 'rollover' provisions found in section 1045. Chairman Kerry also is to be commended for his work on the Finance Committee addressing the problems posed by the IRS proposal regarding the imposition of withholding taxes on statutory stock options. NVCA is pleased with the Chairman's work in these areas and looks forward to working with him and the Committee in finding ways to stimulate investment in America's small businesses.

Recommended Policies to Stimulate Capital Formation and Entrepreneurial Activity:

• Targeted capital gains relief:
Congress can enhance small business access to capital by concentrating on targeted capital gains relief. Focusing on two specific areas under the Internal Revenue Code (having to do with qualified small business stock) would not only increase the amount of capital available to small businesses, but it would also restore Congress' original intent of several years ago to provide incentives for investors to fund small, growing firms.

• Enhancing IRC Section 1202:
Congress should eliminate Internal Revenue Code Section 57(a)(7), which treats a percentage of capital gains excluded from 'regular' taxable income under IRC Section 1202 attributable to the disposition of qualified small business stock (QSBS) as a tax preference item for alternative minimum tax (AMT) purposes. This will ensure that a significant differential exists between overall capital gains rates and the rates applicable to gains realized on dispositions of QSBS and thereby restore the incentive to invest in such stock that Congress intended to create when it enacted Section 1202 in 1993.

As mentioned above, Chairman Kerry and Sen. Cleland have introduced legislation, S. 1676, which would expand on section 1202 of the tax code by significantly increasing the capital gains exclusion of gains on qualified small business stock; shorten the required holding period from five years to three years; and raise the size of eligible businesses to those with gross assets of $100 million, indexed for inflation. These provisions of S. 1676 would greatly enhance the effectiveness of section 1202 and would stimulate significant equity investment in these small businesses.

• Issue regulations under IRC Section 1045 regarding capital gains 'rollover':
Congress should direct the Treasury Department to issue regulations under IRC Section 1045 addressing how the capital gains 'rollover' provisions of that section apply when a partnership disposes of QSBS and reinvests the proceeds in other QSBS.

Section 1045 allows taxpayers other than corporations that dispose of QSBS (as defined in section 1202) held more than six months to defer tax on the sale of those assets if they invest the proceeds in other QSBS within 60 days of that disposition. In 1998, Congress amended Section 1045 to make clear that taxpayers holding stock through a partnership could qualify for the benefits of that provision.

Unfortunately, Section 1045 is silent (and the Treasury Department has issued no guidance) regarding how partners can obtain rollover benefits in the context of a variety of very common transactions involving partnerships. For example, virtually all venture managers and most venture investors hold partnership interests in a number of venture capital partnerships. No guidance is available, however, with regard to how a partner's share of gains attributable to one partnership's disposition of QSBS can be rolled over if another partnership, to which that partner has contributed capital, makes a timely investment in other QSBS.

This problem and others could be easily corrected if Congress were to instruct the Treasury Department to issue regulations governing the application of Section 1045 to partnerships. Issuing regulations will fulfill Congress' legislative intent and increase access to capital by our high growth companies.

S. 1676 also would be very helpful in this area by extending the rollover period from 60 days to 180 days. This extension would allow investors added flexibility in investing proceeds in additional promising start-ups.

• Alternative Minimum Tax (AMT) Repeal:
The 30-year-old alternative minimum tax (AMT) system exists separate from, but parallel to, the regular tax system. Under the AMT scheme, taxable income is modified by an intricate series of "adjustments" and by "preference items" to arrive at alternative minimum taxable income. The application of the AMT frequently results in a higher tax payment than required by the regular income tax system.

The AMT is particularly cruel to entrepreneurs. Many of our leading high-tech regions are in high tax states or jurisdictions. As such, many taxpayers are falling into the AMT because the high cost of property taxes and income taxes in these areas, which are not allowed as AMT deductions. Employees who are not reimbursed for their business expenses are injured as well, because these types of miscellaneous deductions are not allowed for AMT. Perhaps worst of all is the fact that incentive stock options are an AMT-tax-preference item. With the dramatic decline in technology stocks, entrepreneurs who exercised these options when the market was at a healthier level are now finding themselves paying taxes on phantom income.

Due to the fact that AMT is not indexed for inflation, last year's tax cut of some $1.35 trillion from the regular tax system will cause an estimated 1.5 million more taxpayers to be affected by AMT in 2002, for a total of 4.5 million, according to a Joint Committee on Taxation report. In 2010, the total number subject to the tax is estimated to be 26.9 million, of whom 12.2 million will have been placed into the system by the tax plan.

Past research by the prominent economic analysis firm DRI/McGraw-Hill concludes that the repeal of the AMT would, among other things, increase fixed investment, expand the capital stock in the economy, increase labor productivity, and reduce the cost of capital by a significant amount.


• Halting IRS Proposal to Require the Imposition of Withholding Taxes on ISOs:
Longstanding Treasury policy held that statutory stock options, including incentive stock options (ISOs), were not subject to employment tax withholding. The Treasury and IRS reversed this policy in 2001 by issuing proposed rules that would impose employment tax withholding on the exercise of these options beginning in January 2003.

These options are not taxed as income when they are exercised. Instead, the employee pays a tax on the capital gain at the disposition of the stock. As such, a tax deduction is not available to the employer as is the case with non-qualified options.

ISOs are widely used by both entrepreneurial and established U.S. companies. A recent survey by the National Center for Employee Ownership (NCEO) revealed that 82% of venture-backed companies offer ISOs and 62% provide only ISOs. A separate NCEO survey indicated that 44% of all surveyed companies offered ISOs to all employees.

Small, high growth companies use ISOs to attract, retain, and incentivize their employees. These employee equity participation plans are particularly useful to small, entrepreneurial firms since these options offer beneficial tax treatment and since many of these small companies cannot utilize the tax deduction that comes with non-qualified options.

In 2002, workers will pay 6.2% in Social Security taxes on the first $84,900 they earn. There is no cap on Medicare, which taxes 1.45% of all wages. Companies pay an equal amount on their workers' behalf, bringing the total up to 15.3%. In addition to the direct costs in taxes, which, because of the Social Security wage base will hit rank-and-file workers the hardest, employers will face new and heavy administrative costs in implementing the proposed IRS policy.

If this regressive tax increase is allowed to go forward small, entrepreneurial firms will be overwhelmed by the costs associated with administering the tax collection. This will have the effect of either diverting significant capital resources away from the core business to funding a new tax administration plan or it will discourage these companies from offering this important benefit to their employees in the first place.

Legislation preventing implementation of the IRS proposal (H.R. 2695) was included in the Pension Security Act of 2002 (H.R. 3762), which was recently passed by the House. The Senate Finance Committee is expected to take up its own pension proposal later this spring. Whether the Finance Committee includes a similar provision in this bill remains to be seen.

Importantly, Sen. Kerry and nine of his Finance Committee colleagues recently wrote to Treasury Secretary Paul O'Neill urging the Administration to 'reconsider the issuance of these proposed rules and, at a minimum, extend these new withholding requirements beyond 2003 to provide Congress adequate time to review the issue.'

Conclusion:
America's small, entrepreneurial firms have been the catalyst to our economy's growth in the past and will continue to be a key determinant to our future prosperity. It is widely recognized that the lynchpin to their success is access to adequate capital resources. Congress can provide no better service that to create policies that facilitate this capital formation.

Senate Committee on Small Business & Entrepreneurship May 22, 2002