Venture Capitalists Win Big Tax Break in IRS Restructuring and Reform Bill

(July 10, 1998) Silicon Valley interests are demonstrating their growing political power in Washington. The latest evidence is the venture capital industry success in quietly pushing through the Congress a major capital gains tax break for people who invest in venture capital partnerships.

The bill, which passed the House June 25, and the Senate yesterday, will allow anyone who invests via a venture capital partnership, to roll over tax free a gain from the sale of a "qualified small business stock" when the proceeds are reinvested in another small business stock. This new provision is attached to the IRS restructuring and reform bill.

HR 2676 is a huge bill which will increase taxpayer rights and restructure the IRS.  It is widely popular in the Congress, and President Clinton has said that he will sign it.

Capital gains taxes are paid on profits made on investments in stocks, bonds, real estate and collectibles.  Section 1045 currently provides that individual taxpayers may rollover tax-free any gain realized on a sale of "qualified small business stock" when the sale proceeds are reinvested in another qualified small business stock. The rationale for this provision is to encourage individuals to invest in emerging growth companies, and also to encourage them to reinvest any profits once the original investments mature. However, the "rollover" benefits of §1045 is currently limited to individuals.

What the new tax bill does is extend the benefits §1045 to noncorporate investors, including venture capital partnerships. It will encourage people to invest in venture capital funds, which are a traditional source of seed money for high-tech computer and Internet industry companies.

While there is not yet any statistical data on who is actually availing themselves of the existing rollover provision, or who would use the new provision, Mark Heesen of the National Venture Capital Association predicted that the types of companies most likely to benefit would be "Internet, telecommunications, software, biotech, and medical devices."

The law firm of Wilson Sonsoni Goodrich & Rosati (WSGR), which lobbied for the bill, described the bill in its website as "relief for the venture capital industry."

Western Association of Venture Capitalists President Philip Gianos, who is also with venture capital firm InterWest Partners, described the bill in a WSGR press release: "This legislative fix reflects an increased recognition inside Washington of the crucial role venture capital funds have played in the success of Silicon Valley and other segments of the U.S. economy."

Most people who have been involved in the process of enacting the new tax break into law are very reluctant to talk about it. This is very different from the Internet Tax Freedom Act ("no new net taxes"), which passed the House on June 23.  Congressman have been falling over themselves to claim credit for the ITFA, associate themselves with it, and thank their colleagues for all their hard work. The House debate on the bill resembled an Academy Awards ceremony as much as a legislative debate.

In contrast, the venture capitalists' tax break was pushed through quietly. Most of the venture capitalists, lobbyists, lawyers, committee staff, Treasury Department officials, and legislators who worked on its passage do not want their names publicly associated with it. Most who were contacted by Tech Law Journal refused to take or return phone calls, declined to answer questions, or claimed to be unfamiliar with the provision.

Lawyers from the high tech law firm of Wilson Sonsoni, and two industry groups, the Western Association of Venture Capitalists and the National Venture Capital Association, were active in seeking passage of the tax break. Wilson Sonsoni, which represents many venture capital partnerships and companies receiving seed money from VC firms, encouraged clients and others to write letters to key legislators, committee staff, and Treasury Department officials. 

A January 7 letter to its clients and others stated: "we believe the likelihood of success would be improved if letters were submitted by other concerned members of the venture capital community. To this end, we have taken the liberty of enclosing the names and addresses of selected persons to whom letters may be addressed."

WSGR's Glen Kohl also personally lobbied the Office of Tax Policy. Until recently Kohl ran that office, as Deputy Assistant Secretary of the Treasury for Tax Policy. Prior to that he was its Tax Legislative Counsel.  Kohl is now head of WSGR's tax department. Jonathan Axelrad, one of the leaders of WSGR's venture capital fund practice, worked with Kohl in this effort.

Glen Kohl's strategy in dealing with the Office of Tax Policy and congressional committee staff was to label the new provision a "technical correction." However, Mark Heesen of the NVCA stated in an interview that "it really is a new provision, because it will now for the first time be able to be used by venture capital firms."

The venture capital groups also lobbied for the provision. Heesen stated that "we wrote letters to Treasury, House Ways & Means, Senate Finance, and talked to policy makers." In addition, the NVCA website states that "the NVCA influenced this debate through congressional testimony, PAC contributions, grassroots activities and active participation in coalition activities."

Campaign contributions likely played a significant a role.  According to Federal Election Commission records, a lot of money has been contributed by venture capitalists. For example, in the 1998 election cycle the National Venture Capital Association has already given $62,000 to congressional party organizations and PACs, and $33,000 to members of the House Ways and Means Committee and the Senate Finance Committee. And of course, it has given more to other legislators. In addition, a report filed with the FEC on June 22 shows that the NVCA had a campaign chest of about a quarter million dollars as of the end of May.  This is money yet to be contributed.

Also according to FEC records, almost all of the money raised by the NVCA came from individuals who listed their occupation as venture capital. Moreover, the contributions made by these individuals directly to parties, PACs, and candidates is far more that the money flowing through the NVCA PAC.

Of course, both the NVCA and these individuals are concerned about issues other than this venture capital tax break. The NCVA was active in the defeat of Prop 211, and it worked for passage of the Private Securities Litigation Reform Act (PSLRA). And currently, it is working for passage of the Securities Litigation Uniform Standards Act (SLUSA), an increase in the annual cap on H1B visas, and free trade legislation.

The IRS reform bill will also restore the holding period for capital gains to 12 months from the current 18 months, so that many investors will pay taxes at the more favorable capital gains rate of 20 percent, rather than at their regular marginal rate of up to 39.6 percent.

The IRS reform bill is best known for its taxpayer protection provisions.  It will shift the burden of proof from the taxpayer to the IRS in some tax court cases, and make it easier for taxpayers winning their tax cases to have their costs reimbursed by the government. It also will forbid the IRS from forcing people to pay interest and some penalties if it did not notify them of the problem within 18 months of filing their return.