The Qualified Small Business Stock exclusion, enshrined in Section 1202 of the Internal Revenue Code, permits early-stage venture capital firms and angel investors in high-tech startups, those startups’ founders, and early employees to avoid paying any federal income tax on the capital gains from the eventual sale of early-issued shares in these firms. The QSBS exclusion, which was first enacted into law 30 years ago to promote the creation of these kinds of startups, has undergone major revisions since then. Today, the QSBS exclusion provides tax breaks to those who demonstratively need them the least.

This unnecessary tax break costs the U.S. Treasury an estimated $2 billion to $3 billion a year in lost revenue now and well into the next decade. And those estimates may be seriously understated due to the opaque attributes of the public reporting on the use of the QSBS tax exclusion.

The QSBS exclusion today permits avoiding all taxes on capital gains arising from the sale of early-issued C-corporation stock—a narrow exclusion because more than 90 percent of small businesses in the United States (defined as having less than $10 million of annual revenue) are organized as something other than C-corporations.1 As a result, the QSBS exclusion exacerbates U.S. income and wealth inequality by targeting a tax break toward savvy and already wealthy high-tech investors and (often repeat) entrepreneurs who are perfectly willing to take risks with their money and time without any encouragement from the tax code.

This issue brief details the history of the QSBS exclusion to show how it became a vehicle for perpetuating income and wealth inequality. I then detail the extent to which the revenue losses associated with the QSBS exclusion are understated, perhaps significantly so. I then turn to potential options for reform, among them repealing Section 1202 of the tax code or amending it so that the sweeping 100 percent deduction available today is scaled back for taxpayers with excessively high incomes.

Read the full article about capital gains tax breaks by Manoj Viswanathan at Equitable Growth.