Farwah Jafri | May 16 2021
President Joe Biden’s American Families Plan seeks a historic tax hike on the investment returns of the top earners. The aim is to target the richest Americans to help fund his aid programs of social spending.
However, according to the latest CNBC reports: “Taxes on the wealthy may increase regardless of that plan’s success in Congress.”
At present, the equity holders are taxed at a 20 percent base rate. The new tax rate, coupled with an existing surtax on investment income, means that federal tax rates for affluent investors could be as high as 43.4%. In other words, the capital gains tax hike would amount to roughly a doubling of the tax rate. The question now is: How likely this significant capital gains tax hike could affect the startups, the employees and the owners?
You might not have a dog in this fight if you are earning less than $1 million in a year. Moreover, the bill is yet to become a law, and with the wealthy Americans balking at higher tax rates and Congress hashing out the legislation, there is a high chance that the exact percentages and stipulations are likely to change long before it is signed.
Yet there is a good reason for some, other than the ultra-affluent, to feel anxious about the capital gains tax hike. It is those non-millionaire business owners who might have a million dollars or more from time to time and may want to sell their business or anybody else who may want to buy or sell their large assets.
Talking of small businesses, the Biden capital gains tax hike would have a huge consequence on the startups too. Such an enormous tax hike can hamper investment, especially that in the high-growth startups bringing in groundbreaking ideas and disruptive innovation. As a matter of fact, it’s the huge capital gains that tempt the investors to put their money in such high-risk investments. The more outsized the return on an investment, the more you crave for the results, daring to plunge into the risky investments.
Capital gains tax hike means a cut in returns which would no doubt result in reduced financing for small businesses. With a 1-in-10 chance they hit it big, the angel investors would be more prompted to alter their course and opt for safer investments. This may mean more investment in larger businesses that have a proven track record of ROI. So, we can safely assume that the economy may see a steep decline in the creation of tech companies, those involved in new drug discoveries, and other innovative businesses due to lack of capital.
The political wish casting is likely to have its bearing on the future of the aspiring entrepreneurs too who would certainly take a hit by this sharp capital gains tax hike. With such low incentives to offer to the investors, their business plans may end up in trash. A better option would be taking up safer wage jobs than to consider launching their startups. Such a damaging effect on entrepreneurship is surely troubling.
These tax hikes would additionally challenge technology clusters such as the Silicon Valley. Such clusters have thrived as capital gains have been reinvested in the creation of another series of startups. Higher taxes would result in money flowing out of these clusters, with nothing much left to recycle into new ventures. Not to mention, the death of job creation!
Although the anticipated hike likely would not affect the average startup employee getting equity-based compensation as they are not yet in the highest tax bracket, yet the suggested tax plan may create a significant unintentional load on startup employees. Amid the uncertainty and ambiguity around what shape the new tax legislation will take or if it will see the day of life at all, the startup employees need to keep in account the changing scenario when planning what to do with their exercisable equity, and when to exercise it.
Equities remain to be the most reliable, top earning assets, especially for those employees with a long time before they retire. So, whatever the tax situation be, the startup employees should be wary of getting themselves involved in any financial risks that will harm their long-term wealth.
The market can get flooded with stock sales in case the startup founders and employees, to avoid the effect of capital gains tax hike, decide to sell their stocks prior to the new tax rates. Having said that, exercising their stock options can prove beneficial for the startup employees. Typically, the assets which are held over a year, enjoy preferential tax rates, which is not the case with those held for less than a year.
As per President Biden’s suggestion, the long-term capital gains rate would be raised to the highest ordinary income tax rate on income over $1 million. It means that those who make over $1 million on the sale of their shares post-IPO or as part of an acquisition would not be able to enjoy the preferential tax rates. Many employees sell the stock a year after exercising to benefit from long-term capital gains tax. Under the new legislation, if it happens, they may be limited to the amount resulting from the higher share prices that they can convert to preferential capital gains tax depending on their income levels and when they sell. So even if there is capital gains tax hike, exercising early could prove beneficial as many employees may still strategize around selling up to a certain number of shares at preferential rates every year.
Another step which could offer big incentive to exercise their stock options so to limit taxation on shares is to move away from high-tax states such as California and New York to states like Texas and Florida which are no-income-tax states.
It is still uncertain how Biden’s capital gains tax plan may end up in a passed bill. With so much hullabaloo over the tax hike, there is a high probability that the new bill is likely to look far different from the originally proposed plan. Whatever the new legislation be and whether there is any such capital tax gains hike, this should not cause a panic amongst the startup employees or cause them to stay away from exercising their stock options. In fact, they should consider it when devising their equity plans. When it comes to employee equity, what works the most is to have a plan of action and the right timing.
So, ponder over the benefits and drawback of exercising these options today than to wait until after an IPO.
Farwah is the Product Owner of Monily. She has an MBA from Alliance Manchester Business School, UK. She is passionate about helping businesses overcome challenges that hamper their growth, which is why she is working at Monily to facilitate entrepreneurs to efficiently manage business finances and stay focused on growth.