Equity crowdfunding, created by the JOBS Act in 2012, will finally become legal on May 16th. The tax code, however, makes it almost impossible for millions of small businesses to use equity crowdfunding to raise growth capital. The tax law needs to be amended to eliminate this impediment to small firm capital formation.
There are 4.2 million corporations, mostly small businesses, that are S corporations. They have 9.2 million shareholders. S corporations are not double-taxed. Shareholders must report the S corporation’s income on their personal tax returns and pay tax on the income. An eligible corporation may elect to be an S corporation. To be eligible, a corporation may not, among other restrictions, have more than 100 shareholders.
The Securities Act of 1933 makes it generally illegal to sell securities unless the offering is registered with the Securities and Exchange Commission (SEC). Making a registered offering (often called “going public”) is a very expensive proposition and well beyond the means of most small and start-up companies. The SEC estimates that an initial public offering (IPO) typically costs $2.5 million in legal, accounting and other costs and that public companies have continuing compliance costs of about $1.5 million.
The 2012 JOBS Act was a bipartisan achievement of consequence. It improves the regulatory environment for entrepreneurial capital formation. It established a crowdfunding exemption from the Securities Act registration requirements which is designed to allow small companies to use the internet to raise up to $1 million of capital in small amounts from a large number of investors. The crowdfunding exemption will be effective May 16, 2016.
So-called Regulation A plus, also created by the JOBS Act, expands Regulation A to allow companies to raise up to $50 million from the public. The new Regulation A rules were effective June 19, 2015. While generally imposing greater obligations on the companies using it, it too allows companies to raise capital from a large number of small investors.
The problem is that if an S corporation is raising small amounts of capital from a large number of investors using either the crowdfunding exemption or Regulation A plus, it will quickly have more than 100 shareholders and be disqualified as an S corporation. That means the corporation will be double-taxed at both the entity level and the shareholder level. A company that raises $1,000 each from 101 shareholders will have raised only $101,000 but no longer be eligible for S corporation status.
Well-advised S corporations will be told simply that they cannot practically use crowdfunding or Regulation A. They will then have to either use less attractive means of raising capital or do without the investment altogether. Less well-advised S corporations will use crowdfunding to raise capital and then find, when they consult with an accountant to file their tax return, that they are no longer qualified to be an S corporation and may be on the hook for a large tax.
Rep. French Hill, R-Ark., has introduced legislation (H.R. 4831) that would address this problem. The legislation would amend the Internal Revenue Code so that shareholders who only acquired their shares via a crowdfunding offering or a Regulation A offering would not count towards the 100 shareholder S corporation limit. This legislation would eliminate an important impediment to capital formation for small S corporations and promote job creation, innovation and higher wages.