Investing in a Qualified Small Business before Year-End Allows for 100% Capital Gain Exclusion upon Sale

November 17, 2010

The Small Business Jobs Act of 2010 provides a total exclusion of gain for sales of qualified small business stock. This new provision affords a window of opportunity for investors and corporations who close an equity financing or other stock acquisition transaction before year-end to eliminate taxable gains for shareholders upon future sale of the stock. To take advantage of this tax benefit, the stock must be acquired between Sept. 27 and Dec. 31, 2010, and the acquirer must hold the stock for five years. [Update – this provision has now been extended so that stock acquired through December 31, 2011 may be eligible for this benefit.]

The opportunity provided by this new law is particularly important because the exclusion applies for purposes of the Alternative Minimum Tax as well as the “regular” income tax. Also, unlike similar benefits, there is no income phase-out for this tax break. The value of the exclusion will be further enhanced if long-term capital gains rates increase after Dec. 31, 2010. Although Section 1202 has for some time provided for special tax treatment of small business stock, it has not been as important of a planning tool because of certain severe limitations, including only a partial exclusion of gain as well as Alternative Minimum Tax consequences. The Small Business Jobs Act temporarily removes these limitations.

Who is Eligible for the Exclusion?

Only non-corporate taxpayers qualify for this exclusion. The stockholder must generally acquire the stock in an original issuance from the corporation in exchange for money or other property (not including stock), or as compensation for services. This provision is available to outside investors in the stock (not convertible notes, warrants or other debt instruments) of a small business, and to business founders who acquire additional stock (but not options or phantom stock) in their own businesses. The amount of gain eligible for the exclusion is limited to the greater of $10 million or 10 times the taxpayer’s investment in the qualified small business.

Certain special rules apply to individuals owning stock through limited liability companies, partnerships and S corporations. Special “tacking” rules apply to stock acquired or disposed of in certain nontaxable transactions (like a gift or a Section 351 transaction). One effect of these rules is that a stockholder may be able to preserve the special tax treatment of his or her stock, even if the stock is disposed of prior to the expiration of the five-year holding period, if it is exchanged for stock of another corporation in certain types of transactions.

What is a Qualified Small Business?

A qualified small business, generally, is a domestic C corporation (not an S corporation) meeting the following requirements:

  1. The aggregate gross assets of the corporation at all times since inception up to the time immediately after the stock issuance do not exceed $50,000,000.
  2. During substantially all of the taxpayer’s holding period, at least 80% of the corporation’s assets are used in the active conduct of one or more “qualified trades or businesses.”

A qualified trade or business is defined as any trade or business other than certain service businesses such as banking, farming, lodging, and certain mining and natural resource operations. Certain start-up activities and research and development activities may qualify as the active conduct of a trade or business for these purposes.

The corporation cannot undertake certain disqualifying redemptions. If a corporation redeems any stock from a stockholder within two years before or after the acquisition of stock subject to these provisions, the special tax treatment will not apply with respect to that stockholder. Likewise, if a company undertakes significant (5% of outstanding stock) redemptions generally within one year before or after the issuance of such stock, the special tax treatment will not be available to any of the company’s stockholders.

What Should a Corporation and Its Investors Consider?

There are several tax planning considerations that corporations and their investors may wish to consider taking before year-end to take advantage of this 100% exclusion. Possibilities include but are not limited to:

  • Issuing C corporation stock in connection with the formation of a new corporation or an equity financing by or investment in an existing corporation. The formation of a new corporation could be the result of a conversion of an existing partnership or limited liability into a corporation; also, an equity investment in an existing corporation could be the result of a a conversion of debt to equity. In certain cases, the issuance might represent the acceleration of an already-planned transaction.
  • Compensatory stock grants to employees, option or warrant exercises by employees, or making a Section 83(b) election on previously issued restricted stock.

When making an investment in a small business corporation, investors need to consider all the variables inherent in acquiring stock or investing capital in a business enterprise, and consult with their tax advisors. For example, in many instances limited liability corporations, partnerships, and in certain instances, S corporations, will continue to be the more tax-favored structures for operating a small business. With this limited window to participate in significant tax savings, corporations and investors should act quickly in considering how they may take advantage of this helpful tax benefit.