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Obama proposes no capital gains tax on qualified small business stock

May 13, 2009

This week, the Obama Administration released the first comprehensive summary of its budget proposal. The budget proposal is wide ranging, and includes, for example, proposed changes with respect to the taxation of “carried interests” in partnerships, as well as sweeping reform of the international tax area. One proposal would dramatically improve the treatment of “qualified small business stock” issued after February 17, 2009.

The budget proposal would modify IRC Section 1202 to provide for a complete exemption from capital gains tax for qualified small business stock issued after February 17, 2009 and held for five years, and the amount excluded would not be added back for alternative minimum tax purposes. If enacted, this would significantly enhance the tax incentives currently available for qualified small business stock. Under current law, the exclusion for purposes of the regular income tax system of 50% of the recognized gain on the disposition of qualified small business stock (which was increased by the recent American Recovery and Reinvestment Act to 75% for issuances in 2009 (after February 17, 2009) and in 2010) is substantially undercut by the combination of the high rate of tax (28%) applicable to the non-excluded portion of the gain under the regular income tax and the interplay between the AMT rules and Section 1202. Thus, historically, the principal federal tax benefit of qualified small business stock has been the ability to achieve “rollover” treatment of the proceeds from the sale of qualified small business stock under IRC Section 1045.

In light of the potential for this significant benefit associated with qualified small business stock, all venture financings should be analyzed very closely from a qualified small business stock standpoint. In addition, post-financing transactions, particularly stock redemptions, that potentially could undermine qualified small business stock status should be carefully reviewed.

The relevant provisions of the summary of the budget proposal related to qualified small business stock are below.

ELIMINATE CAPITAL GAINS TAXATION ON INVESTMENTS IN SMALL BUSINESS STOCK

Current Law

Taxpayers other than corporations may exclude 50-percent (60 percent for certain empowerment zone businesses) of the gain from the sale of certain small business stock acquired at original issue and held for at least five years. Under ARRA the exclusion is increased to 75 percent for stock acquired in 2009 (after February 17, 2009) and in 2010. The taxable portion of the gain is taxed at a maximum rate of 28 percent. Under current law, 7 percent of the excluded gain is a tax preference subject to the alternative minimum tax (AMT). The AMT preference is scheduled to increase to 28 percent of the excluded gain on eligible stock acquired after December 31, 2000 and to 42 percent of the excluded gain on stock acquired on or before that date.

The amount of gain eligible for the exclusion by a taxpayer with respect to any corporation during any year is the greater of (1) ten times the taxpayer’s basis in stock issued by the corporation and disposed of during the year, or (2) $10 million reduced by gain excluded in prior years on dispositions of the corporation’s stock. To qualify as a small business, the corporation, when the stock is issued, may not have gross assets exceeding $50 million (including the proceeds of the newly issued stock) and may not be an S corporation.

The corporation also must meet certain active trade or business requirements. For example, the corporation must be engaged in a trade or business other than: one involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or any other trade or business where the principal asset of the trade or business is the reputation or skill of one or more employees; a banking, insurance, financing, leasing, investing or similar business; a farming business; a business involving production or extraction of items subject to depletion; or a hotel, motel, restaurant or similar business. There are limits on the amount of real property that may be held by a qualified small business, and ownership of, dealing in, or renting real property is not treated as an active trade or business.

Reasons for Change

Because the taxable portion of gain from the sale of qualified small business stock is subject to tax at a maximum of 28 percent and a percentage of the excluded gain is a preference under the AMT, the current 50-percent provision provides little benefit. Increasing the exclusion would encourage and reward new investment in qualified small business stock.

Proposal

Under the proposal the percentage exclusion for qualified small business stock sold by an individual or other non-corporate taxpayer would be increased to 100 percent and the AMT preference item for gain excluded under this provision would be eliminated. The stock would have to be held for at least five years and other provisions applying to the section 1202 exclusion would also apply. The proposal would include additional documentation requirements to assure compliance with the statute.

The proposal would be effective for qualified small business stock issued after February 17, 2009.

Written by Yokum · Filed Under Founders 

Comments

  • nevillegovender
    I see health companies are excluded from capital gains exemption. This would mean home health care agencies I presume?

    This sure would be a good reason to expand but will not help our industry if health care companies are excluded.
  • I assume there will be more details on this next week. Interesting that it dates back to May 09 and maybe even before.

    We are small sub-prime auto finance business actively seeking investment. Sounds like we would be excluded from taking advantage of this.

    A real shame as we have a potential investor who would jump on opportunity to avoid capital gains tax.
  • Joe
    Hi - I incorporated at the end of 2006 in New York, however no stock has been issued yet. I plan to issue stock to my partners at the end of this year. Does that count for "small business stock issued after feb. 17, 2009?" thanks for your help!
  • @Joe - it sounds like your stock isn't issued yet.
  • Dave
    What is the status of this proposal ?
  • No update.
  • Tiberius
    Why all the exclusions from the definition of a qualified small business under this statute? What is really left? Also @Andy Freeman -- I agree that there is a major problem with the current laws against private investment in small businesses that exclude non-accredited investors. Something needs to change on that front as well.
  • Andy Freeman
    Note that this proposal does not provide any direct benefit to most of us because we're not accredited investors. As a result, we can't buy stock in most small biz without founding said small biz, working for it, or being related to a founder.
  • Cayla
    Really? Because to me it sounds like although you may not be an "investor", those that are will help stimulate small business growth, which in turn will create jobs and wage increases to YOU.
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