Squashing Small Business Without Really Trying

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I was recently invited down to Washington DC to represent the venture capital industry at a Small Business Administration Office of Advocacy gripe session. At issue were the unintended consequences of an obscure corner of the Sarbanes Oxley Act known as 409(A). Bureaucratic weirdness and utter futility are the best words that come to mind.

At the meeting or attending by speakerphone were a smattering of small business advocates, a cheerful fella from the SBA, and a few sullen representatives from Treasury and the IRS who were nonetheless treated with great deference. I was the only person that didn't already know everybody. The small business advocates weren't sure what a venture capitalist was doing there but were happy to make common cause.

A word about what brought us together.

Back when Enron and WorldCom were considered large scandals Congress belched out a whopper called Sarbox, otherwise known as the lawyers and accountants full employment act. One trick Enron perps used to rob powerless, distant and uninvolved shareholders was gorging on deferred compensation. 409(A) created a labyrinth of rules tied to draconian tax penalties that would sting any corporate executive trying to repeat such shenanigans.

But venture capital backed startups don't have powerless, distant and uninvolved shareholders. We not only hold preferred stock but sit on the board and usually run the compensation committee. And startups don't offer deferred compensation. They incentivize employees and executives with stock options. These are both illiquid and not worth the paper they're printed on unless and until the company achieves enough success to generate a positive exit.

You'd be correct in observing that 409(A) doesn't solve any problems that actually exist in closely held private companies. Yet because Congress didn't explicitly exempt such companies they have to follow the same rules as IBM and Shell Oil.

When my turn came to speak I pointed out that in our rarefied community 409(A) is an affliction akin to a persistent toenail fungus. It is neither debilitating nor curable, thought it can be neutralized with a combination of cash and institutionalized corruption. I described exactly how the corruption worked and that it generally cost each of our portfolio companies between $5,000 and $15,000 a year. This money fuels a professional protection racket that spits out fanciful valuation reports designed to shield employees from getting nailed with 409(A) penalties in the unlikely event that their stock options ever turn out to be worth something.

Bottom line, I opined, 409(A) is a tax on entrepreneurship except it is paid to lawyers, accountants, and unemployed investment bankers instead of to the government. No discussion ensued. Everyone just looked at me with the unspoken words, "You think you have problems?"

That's when I learned about the misery waiting to be inflicted on owners and employees of workaday small businesses like your dry cleaner, plumber, or even your family doctor. In all too many cases the 400 pages of Treasury regulations that define 409(A) can be a dagger pointed at their hearts. Like characters in a Kafka novel, most of the victims will never know about these nightmarishly complex rules until they are hauled in for a dreaded audit and find out that the money tied up in their business that they were counting on for retirement just went poof.

A representative from the Small Business Council of America laid out a parade of horribles in a whitepaper you can find on their website. Something as simple as paying out a retiring partner his share of accounts receivable - no small sum in many businesses - can trigger taxes and penalties far in excess of the payout. In some cases an employee can owe tax, interest, and penalties on tens of thousands of dollars of deemed income that is never even received!

All agreed this was surely not intended by the law's authors. Yet how to fix it? The Treasury and IRS officials indicated that they don't make the laws, they just enforce them. If you want to change the statute go talk to Congress.

One sentence exempting privately held companies from 409(A) would do the trick, but that's not how Washington works. Constituencies have to be assembled. Congressmen have to be greased. But how does one solicit baksheesh from small businesses to fix a law that they don't even know they are breaking? In today's climate the Congressional Budget Office also has to score any change revenue neutral. This could be tricky since the IRS could theoretically hire enough auditors to generate any given level of fines.

I suggested latching on to President Obama's promise to eliminate useless and stupid regulations but no one believed something this arcane would garner support. Since journalists don't have the attention span to understand much less describe the issue, how about trotting out a few colorful and sympathetic victims? They took that under advisement but weren't sure the media would ever portray a successful businessman as sympathetic. The only thing this group was sure of is that they would meet again. And again. And again.

Making it just another day in the belly of the beast.

 

Bill Frezza is a fellow at the Competitive Enterprise Institute, and a Boston-based venture capitalist. You can find all of his columns, TV, and radio interviews here.  If you would like to have his weekly columns delivered to you by e-mail, click here or follow him on Twitter @BillFrezza.

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