On May 7, 2009, the Obama Administration released a summary of its proposals for the Fiscal Year 2010 budget. The proposals include an elimination of capital gains tax on the sale of qualified small business stock issued after February 17, 2009. This proposal, if enacted, would significantly increase the tax benefits of qualified small business stock and is intended to spur investment in small businesses.
Background of Current Law
Section 1202 of the Internal Revenue Code currently allows an exclusion from income of 50% of the gain from the sale or exchange of “qualified small business stock” that has been held for more than five years. This exclusion is available to taxpayers other than corporations and is subject to certain additional limitations. Pursuant to the recently enacted American Recovery and Reinvestment Act of 2009, this exclusion was increased to 75% of gain for qualified small business stock acquired after February 17, 2009 and before January 1, 2011.
The actual tax benefit of these exclusions is significantly reduced, however, because the portion of the gain that is not excluded is taxed at a maximum rate of 28% (as opposed to the maximum rate of 15% generally applicable to long-term capital gains under current law) and because a portion of the excluded gain is a tax preference item that is added to taxable income for purposes of computing the Alternative Minimum Tax (AMT).
The budget proposal seeks to exclude 100% of the gain on the sale of qualified small business stock issued after February 17, 2009. Further, no portion of the excluded gain would be a tax preference item for AMT purposes. This change would have a significant favorable impact on the tax treatment of the disposition of qualified small business stock. The change does not affect the taxpayer’s ability under Code Section 1045 to “roll over” the gain on the sale of qualified small business stock to the extent that the proceeds of the sale are used to purchase additional qualified small business stock.
Effect on Venture Capital and Other Investments into Small Businesses
To date, the appeal of the qualified small business stock tax provisions has largely been limited to the “roll over” provisions. With the long-term capital gains rate set to increase from 15% to 20% after 2010, or even earlier for certain taxpayers under the budget proposal, the proposed 100% exclusion of gains on qualified small business stock represents a meaningful benefit.
Venture capital and other investors in private equity are well advised to reacquaint themselves with the disqualification provisions in Section 1202 of the Internal Revenue Code relating to certain stock redemptions that can prevent stock from being treated as qualified small business stock. In addition, for new investments, both issuers and investors should work closely with legal counsel to review the active business and other requirements for qualified small business stock.
IRS CIRCULAR 230 NOTICE: Any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
The following is the actual text of the budget proposal from “General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals,” published by the Department of the Treasury:
TAX CUTS FOR BUSINESS
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.