President Joe Biden’s American Families Plan [read here] unveiled last week included a substantial increase to the capital gains tax — taxes on earnings from investments — but its effect on venture capital may not be as straightforward as it appears.

Biden’s proposed tax overhaul includes hiking the long-term capital gains taxes from 20 percent to up to 39.6 percent for high earners (or 43.4 percent if one includes Medicare surtax) — basically taxing investment earnings as income.

“I think many are taking a wait-and-see approach,” said Gautham Deshpande, an audit partner at EisnerAmper’s San Francisco office who specializes in venture capital funds among other types of funds.

Deshpande said it is possible if some revision to the tax is approved, venture capitalists could change aspects of how they invest, but added there also are ways around the tax that many investors will likely consider to hold onto more of their money.

Section 1202

Perhaps the most obvious benefit that early-stage investors can use is Section 1202 of the IRS Code. The tax law allows for those who invest in Qualified Small Business Stock (QSBS) — which includes tech startups as long as they’re C corporations — to exclude 100 percent of the capital gains made on those investments, if the stock is held for at least five years and is acquired at issue.

The QSBS exclusion — signed into law under the Clinton administration and expanded under the Obama White House — has a limit of $10 million or 10x the basis of the stock sold, whichever is greater.

The law does not apply to LLCs and is often overlooked by taxable investors who could benefit by investing in a C corp that is below a $50 million valuation, said Brian Gaister, a co-founder and managing partner of Maryland-based SaaS Ventures.

“I think (1202) is often missed,” Gaister said of investors’ knowledge of the tax law. “As it relates to venture capital — if you invest in a C corp that meets the criteria — any increase in capital gains tax is minimized by utilizing the benefits of QSBS,” he said.

“It’s the only tax loophole in the world that should exist,” said Elizabeth Edwards, founder and general partner at early-stage investment firm H Venture Partners.

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