VIA U.S. MAIL AND FAX
The Honorable James Risch – Chairman
Committee on Small Business & Entrepreneurship
United States Senate
428A Russell Senate Office Building
Washington, D.C. 20510
Re: Proposals to Incentivize Small Business Growth and Resolve Startup Issues
Dear Honorable James Risch:
I write to you regarding my proposals to incentivize small business growth and resolve recurring startup issues within our nation’s high-tech communities. This letter sets forth several proposals that would reward innovation, encourage new technologies, and support our startup and small business communities.
My law firm, the Royse Law Firm, is a Silicon Valley-based law firm that focuses on small, closely held, and startup companies. We advise such companies on tax, business, and corporate law matters and regularly witness the launch of new industries and demise of old ones. Since I have started practicing law, the business world has changed but the law has not kept up with technology, markets, or business practice. I write to suggest some ways in which government can get out of the way and allow true innovation to thrive.
Ideally, it would be fair for all employees whose sweat equity increases the value of a private company to share in the ownership of that company. But under current tax law, this type of employee compensation policy can be prohibitively expensive. Employees must generally include stock compensation in their taxable income at grant or when the shares become substantially vested. Likewise, stock options are generally included in income upon exercise, which allows for some timing of the income tax, but also subjects them to an expiration date. This means employees who wish to acquire stock in their company may be forced to pay a high amount of income tax in the absence of liquid assets. If an employee cannot afford to pay this tax, then the employee will be discouraged from sharing in the company’s wealth.
The Empowering Employees through Stock Ownership Act (H.R. 5719) was introduced in July 2016 by Rep. Erik Paulsen to help implement better employee compensation policy. The House passed the bill in September 2016, but it was not passed by the Senate before the end of the 114th Congress. If this bill is revived and enacted by the 115th Congress, it will permit growing companies to issue stock to their employees without triggering the immediate inclusion of taxable income. The goal of such legislation is to alleviate the hardships imposed by the tax treatment of stock compensation in small, startup businesses as well as larger, private companies.
To accomplish this goal, the bill allows an eligible employee to elect to defer taxation until an event triggers the cash or cash-equivalent that the employee needs to pay the income tax on the stock compensation, thereby empowering the employee to reap the benefits of increasing the company’s wealth. To help ensure this tax expenditure will be used to properly incentivize shared ownership, the company would be required to provide the stock compensation to at least 80 percent of its workforce. Further, the income deferral would not be available for top management and top paid employees. Thus, this bill provides adequate protections against potential managerial abuse in addition to improving the economic incentives available to hard working employees. For the above reasons, I urge you to support an exemption or deferral of tax on income for equity compensation in startups.
Check-the-Box Election for Independent Contractors
Under current law, there is a presumption that workers are employees, and the IRS will aggressively pursue collection activities against employer-taxpayers that inappropriately classify employees as independent contractors. There is a conspicuous lack of bright line tests, however, for permissible classification variations under both federal tax and labor law standards. Moreover, the states’ varying standards create additional disparities in treatment. The uncertainty and complexity associated with classifying workers subjects the employer to expensive lawsuits, employment taxes, penalties, and interest for misclassification. Class action lawsuits from a misclassified employee can even lead to the bankruptcy of an otherwise emerging business. Thus, the highly subjective and fact-sensitive analysis under common law creates an unnecessary barrier to contract formation and exercising one’s business judgment.
A change in classification also results in a change in the parties’ economic burdens as employers are obligated to pay payroll taxes that would otherwise be borne by the service provider if he or she is an independent contractor. A reclassification of a misclassified employee therefore results in the reshuffling of an economic deck that the parties did not intend.
Section 530 is a safe harbor provision meant to prevent the IRS from retroactively reclassifying independent contractors as employees. To qualify for section 530 relief, an employer must have: (1) consistently treated the worker and similar workers as independent contractors, (2) filed all Forms 1099 for these workers treating them as independent contractors, and (3) had a reasonable basis for not treating them as employees. While there is no explicit definition as to what constitutes a “reasonable basis” for purposes of section 530, the legislative history shows that the reasonable basis requirement should be construed liberally in favor of the taxpayer. Regardless, misclassification is a recurring problem despite Congress’ intent that the IRS show deference to the business judgment of service recipients and not aggressively pursue collection activities in this context.
While an employer can fill out an IRS Form SS-8 to document the basis for his worker classification, taxpayers are currently unable to make a binding election. The modern workaround is to sign a written agreement stating the worker is an independent contractor, but even binding contracts are subject to the IRS’ ad hoc reasonable basis determination for worker classification. This is a waste of government and taxpayer resources. Instead, the policy of liberal construction in favor of the taxpayer should be codified by expanding the 530 safe harbor to classes of persons who can be expected to protect themselves from reclassification. The provision of statutory relief, especially through state preemption, will facilitate business deals and economic growth in our communities.
We support legislation that allows for freedom of contract and the ability for parties to agree among themselves as to their respective rights, liabilities, and obligations. We suggest that contractor status be elective, at least for certain types of workers that can be expected to be able to protect their own interests. Such an approach would not result in any threat to the fisc, as the same net amount of taxes would be due, but rather provide contracting parties with greater certainty that their economic deal will not be rearranged by a regulatory agency.
Startup Visa Program
Immigration is a valuable source of entrepreneurship and innovation in the tech community. This is demonstrated by the Silicon Valley and other tech-heavy regions’ heavy reliance on H1-B visas to bring skilled workers from other countries into their states. These visas are only available, however, to people migrating to the U.S. to work for established companies. Conversely, startup visas can help increase our nation’s human capital and economic output by attracting the best and brightest entrepreneurs from around the world. Thus, it is important to encourage entrepreneurship and facilitate innovation in the U.S. with startup visas so our nation can reap the benefits of emerging industries.
Starting in July 2017, the Department of Homeland Security (DHS) may use its parole authority to grant a period of authorized stay, on a case-by-case basis, to foreign entrepreneurs who own a substantial interest in a U.S. startup that can create a “significant public benefit” and acquire investments from qualified U.S. investors. Known as the International Entrepreneur Rule, this regulation allows entrepreneurs who fit those requirements to stay in the U.S. for 30 months. They can then apply for an additional 30 months if the company shows continued growth and benefit to the American public.
This discretionary parole authority makes it possible for some foreign-born entrepreneurs to legally enter the U.S. to start and grow successful businesses. Such case-by-case opportunities should be codified into a startup visa program so we can offer predictability to nonresident aliens in our quest to attract the best and brightest entrepreneurs from around the world. Implementing a startup visa program with clear procedures for qualified applicants under federal law will lead to additional capital investment, job creation, and revenue. Thus, the codification of this program alone can implement meaningful immigration reform.
Modernize S Corporation Eligibility
Corporations are generally subject to two levels of tax: once at the corporate level and again at the individual level when corporate earnings are distributed. Certain corporations may elect under Subchapter S of the Internal Revenue Code to be subject to a regime in which the earnings are generally taxed only once to the individual owners of the corporation. The Subchapter S rules acknowledge the unfairness and inefficiency of the double taxation of C corporations, especially those that are debt financed; however, because of the limitations on eligibility, Subchapter S does not go far enough in allowing small businesses to compete on a tax-neutral basis. A corporation is not eligible to elect S status unless it has only one class of stock, no non-resident alien (NRA) shareholders, and no non-individual shareholders.
Partnerships (and LLCs taxed as partnerships) are taxed in a manner similar to S corporations except they may have NRAs and non-individuals as owners, as well as multiple classes of interests. Notably, the popularity of such entities belies the notion that pass-throughs are too complicated for typical corporate structures. Accordingly, we would like to see S corporations taxed more like partnerships, thus removing a tax artificiality from the choice of entity decision and allowing companies to conduct business in the most efficient form.
To neutralize tax considerations regarding choice of entity, S elections should be made available to a greater number of small businesses by allowing corporations with preferred stock, NRA shareholders, and non-individual shareholders to be eligible to elect S status. Removing these arbitrary limitations on eligibility would make the S election available to the existing class of parties who are either stuck with the LLC form of doing business or forced to pay taxes twice on the same income. Thus, our proposal is to amend the Code to remove the requirements that an eligible corporation can only have one class of stock and only U.S. individual shareholders.
Create a New Class of Small Business Stock
The Internal Revenue Code contains several provisions that encourage investment in small businesses. One option is to purchase “small business stock.” Congress permits an individual to deduct the loss from a sale or exchange of small business stock as an ordinary loss under Section 1244. Unlike a capital loss, an ordinary loss may fully offset wage income, dividends, or similar ordinary income.
The Code also provides favorable treatment for gains from investing in small business stock under Section 1202. Non-corporate taxpayers may exclude from gross income 50 percent of any gain from the sale of qualified small business stock (“QSB” stock) held for more than five years. In order to qualify, the issuing corporation must have been a C corporation and must have been a C corporation during substantially all of the shareholder’s holding period of the stock. Most small businesses, however, are organized as S corporations or as limited liability companies (LLCs). Thus, the five-year holding period and C corporation requirements are in effect preventing the smallest businesses that are the most in need of funding from issuing investment interests that qualify for QSB stock treatment.
We propose that Congress create a new class of small business stock to encourage investments in S corporations and LLCs. To encourage risk and incentivize early ideas, the class should not have a holding period but may be limited to smaller companies with gross assets under $1 million. This subset would not need to include C corporations or larger companies as they already have access to the income exclusion incentives. The amount taken into account under the new exclusion and its rollover period would remain the same. Creating this class would level the playing field for the most popular types of small business entities by facilitating access to angel investments and startup capital.
Facilitate Innovation with Tax Incentives for R&D Partnerships
Federal research and development (R&D) tax incentives in the U.S. are subject to strict requirements. Current case law and statutory limitations regulate pass-through taxpayers to such an extent that the available deduction and credit are no longer facilitating innovation in the partnership context. Not enough R&D partnerships are able to take advantage of the tax incentives available, and the value of the tax benefit that is being received by those partnerships that are eligible is insufficient to operate as an incentive. We suggest getting rid of these obstacles, at least for qualifying partnerships able to prove their economic substance, by implementing a Research and Experimentation Investment Vehicle (REIV) into the Internal Revenue Code.
Historically, R&D projects were used by high-bracket taxpayers to shelter income by making large investments in mostly speculative endeavors purely to offset their tax liability. This type of shelter was generally organized as a limited partnership to provide limited liability and pass-through deductions to investors. The section 174(a) deduction for R&D expenses, in particular, was being heavily abused and misused to shelter income. Thus, the case law and statutory limitations for R&D partnerships became increasingly strict to eliminate this type of tax shelter. By interpreting R&D requirements in a manner to prevent tax shelters, however, courts have precluded passive partners from using the R&D deduction even though partners in a partnership should be entitled to the deduction when they make non-abusive R&D investments.
Facilitating innovation with federal tax incentives requires crafting an exception under the current rules for R&D partnerships. Implementing a REIV will permit passive partners to use the R&D deduction and/or credit as long as they keep money at risk and comply with existing anti-abuse rules. Designing a REIV in this manner aligns with Congress’ policy goal of incentivizing innovation without abusively sheltering income. The REIV will operate as a carve-out from the passive loss rules, trade or business restrictions, and other relevant limitations such as the AMT. This kind of reform would grant passive partners the same access to R&D tax incentives as other passive corporate investors, thereby leveling the playing field between the U.S. and other countries’ tax treatment of R&D related joint ventures.
Allow Small Businesses to Raise Money through the Use of Finders
For many years, the U.S. Securities and Exchange Commission (the “SEC”) allowed small businesses to engage unlicensed finders to assist them in raising money. These finders served a valuable role in the fundraising process by putting investors in touch with companies who were seeking capital, typically in transactions that were too small to attract the attention of federally regulated broker-dealers. Over the past several years, however, the “finder’s exemption” has been steadily eroded by the SEC through enforcement actions to the point where unregistered “finders” no longer exist.
The de facto regulatory repeal of the finder’s exemption has outlawed an entire industry, with no legislative action at all, resulting in a conspicuous absence of legal alternatives for small businesses seeking capital. The SEC’s brief to the 11th Circuit after the SEC v. Kramer case provides a summary of the SEC’s current view of unregistered finders, wherein any commission payment will cause the recipient to be categorized as an unregistered broker-dealer. There is judicial support, however, for finders to take percentage-based compensation without having to register as brokers or dealers. These courts generally hold something more than just transaction-based compensation is necessary to require broker registration.
The purpose of the SEC is to protect investors, not to increase the transaction costs of startup financing by regulating finders. Registration under these circumstances is inefficient and receives inconsistent treatment from the SEC and courts on appeal. The federal securities law should be liberalized to explicitly exclude finders from broker-dealer registration. A codified finder’s exemption will increase economic efficiency by lowering transaction costs associated with the present law’s uncertainty as well as resolve court splits within the judicial system.
Regulation Crowdfunding (“Regulation CF”) was designed to improve access to capital for small businesses as well as investment opportunities for smaller investors. However, the JOBS Act still requires that the sale of securities occur through a funding portal, i.e., a third-party intermediary registered with the SEC and FINRA. There is also a $1 million investment cap that is limiting small business’ access to capital. Finally, strict disclosure requirements impede small business growth where disclosures can cost up to 20 percent of the raise. Thus, removing registration requirements, increasing the cap, and reducing disclosure requirements is an effective means to encourage more entrepreneurs to consider CF crowdfunding.
The Fix the Crowdfunding Act (H.R. 4855) was introduced by Rep. Patrick McHenry during the 114th Congress. The bill would have amended the Securities Act to allow a crowdfunding issuer to sell shares through a crowdfunding vehicle. The bill would also have amended the Securities Exchange Act to revise the exemptions from SEC registration. The bill was passed by the House in July 2016 but was never passed by the Senate. Several provisions of the bill were then merged into the Financial CHOICE Act.
The Financial CHOICE Act of 2017 (H.R. 10) was introduced by Rep. Jeb Hensarling on April 26, 2017. Subtitle P would remove the individual and aggregate investment caps. It would also allow an issuer to conduct federal crowdfunding without a registered intermediary and remove a significant amount of the existing regulatory requirements on issuers. These reforms permit everyday investors to diversify their portfolios while supporting small business growth. I support easing these restrictions on crowdfunding and effectively increasing access to capital.
We hope that you will seriously consider our proposals set forth herein and that this Congress acts to modernize the law and empower our startups.
Very truly yours,
ROYSE LAW FIRM, PC
Attorney at Law