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
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.
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.
UPDATE (the following is from a WSGR client alert dated October 7, 2010)
The recent enactment of the Small Business Jobs and Credit Act of 2010 (SBJCA) may provide a substantial tax benefit to investors who acquire qualified small business stock (QSBS) on or after September 28, 2010, and before January 1, 2011. Entrepreneurs and investors considering forming or making investments in qualifying corporations, including owners of unincorporated businesses considering incorporation, should be aware of the potential advantages of acquiring QSBS during the relevant time frame.
Under the law prior to the enactment of the SBJCA, Section 1202 of the Internal Revenue Code of 1986, as amended, allowed an individual taxpayer to exclude 50 percent of any gain from the sale or exchange of QSBS held more than five years. This exclusion was increased to 75 percent for QSBS acquired after February 17, 2009, and before 2011. A portion of the excluded gain has been treated as an item of tax preference for alternative minimum tax purposes.
Under the SBJCA, an investor may exclude 100 percent of the gain from the sale or exchange of QSBS held more than five years that is acquired after September 27, 2010, and on or before December 31, 2010. Importantly, such gain is also eligible for exemption from alternative minimum tax, thus effectively eliminating tax on such gain.
Stock of a small business generally qualifies as QSBS if the stock meets certain requirements, including: (i) the small business is a domestic C corporation; (ii) the taxpayer acquired the stock at its original issue in exchange for money or other property (not including stock) or as compensation for services; (iii) the small business is engaged in a qualified trade or business and uses 80 percent (by value) of its assets in the active conduct of one or more qualified trades or businesses; (iv) the aggregate tax basis of the small business’s assets on the date after the stock is issued (including proceeds received in exchange for the stock) is $50,000,000 or less; and (v) with certain de minimis exceptions, the small business has not made any repurchases of stock within the two-year period starting one year prior to the date the stock was issued. A “qualified trade or business” is defined as any trade or business other than (i) any trade or business involving the performance of services, such as accounting, engineering, or consulting, or any other trade or business where the principal asset is the reputation or skill of one or more of its employees; (ii) any banking or financial business; (iii) any farming business; (iv) any mining or oil or gas business; and (v) any business of operating a hotel, motel, restaurant, or similar business.
In addition to the exclusions described above, under Section 1045 of the Internal Revenue Code, a taxpayer who (i) holds QSBS for more than six months (the original QSBS); (ii) sells the original QSBS in an otherwise taxable transaction; and (iii) during the 60-day period beginning on the date of such sale, purchases new QSBS (replacement QSBS) generally will recognize gain on its original QSBS only to the extent that the proceeds from such sale exceed the amount invested in the replacement QSBS.
FURTHER UPDATE (December 17, 2010)
The 100 percent exclusion was extended to QSBS acquired before December 31, 2011.