The proposed changes to the Internal Revenue Code section 1202 could increase interest in investments in small business stock.

Section 1202 of the Internal Revenue Code provides a special partial exclusion from gross income for individual taxpayers of gain from the sale or exchange of qualified small business (QSB) stock held for more than five years. Subject to certain limits, in the case of stock acquired after February 17, 2009, and before January 1, 2011, the gain exclusion is 75 percent and otherwise generally is set at 50 percent.

QSB stock is generally any stock in a domestic subchapter C corporation (a QSB corporation) if as of the date of issuance, both before and after the issuance of the stock, the corporation is a "qualified small business" with gross assets that do not exceed $50 million, the stock was acquired by the taxpayer at its original issue in exchange for money or property (not including stock) or as compensation for services (other than underwriting services) provided to the issuing corporation, and the issuing corporation satisfies certain active business requirements substantially throughout the investor’s holding period of the stock. The amount of gain eligible for exclusion with respect to an individual taxpayer’s investment in QSB stock is the greater of ten times the taxpayer's basis in the stock or $10 million.

Care needs to be taken in structuring investments intended to qualify under section 1202, as the availability of the gain exclusion is subject to a variety of limitations and conditions, including those noted below:

  • The term "qualified trade or business" does not include most professional services (e.g., legal, accounting, engineering, consulting, performing arts and "any trade or business where the principal asset is the reputation or skill of one or more employees") and any banking, insurance, financing, leasing, investing or similar business; any farming business; any business involving the extraction or production of products eligible for a depletion deduction; and any business of operating a hotel, motel, restaurant or similar business.
  • At least 80 percent (by value) of the assets of the corporation must be used "in the active conduct of a qualified trade or business," either directly or through the activities of subsidiaries, during substantially the entire period in which the taxpayer owned the stock. Interests in portfolio stock and securities must be less than 10 percent and no more than 10 percent of the total value of the assets of the corporation can consist of real property not used in the active conduct of a qualified trade or business. There are also rules governing start-up activities and research and development for future qualified businesses.
  • Certain purchases or redemptions of stock by the corporation within specified periods before or after issuance can result in a loss of QSB stock status.

Under current law, a percentage of the excluded gain is an alternative minimum tax (AMT) preference and the portion of the gain includible in taxable income for regular tax and AMT purposes is taxed at a maximum rate of 28 percent (since section 1202 does not permit a taxpayer to both take the exclusion and apply the 15 percent individual long-term capital gains tax rate (introduced by the Jobs and Growth Tax Relief Reconciliation Act of 2003) to the balance). As a result, particularly given the 5 year holding period requirement, section 1202 has had only limited attraction to individual taxpayers.

On March 24, 2010, the U.S. House of Representatives passed H.R. 4849, The Small Business and Infrastructure Jobs Tax Act of 2010 (House Bill), which would increase the gain exclusion under section 1202 to 100 percent for QSB stock acquired after March 15, 2010, and before January 1, 2011. Significantly, in addition, none of the gain would be accounted for as an AMT preference. Therefore, no regular tax or AMT would be imposed on gain from the disposition of QSB stock covered by the proposed amendment provided the 5 year holding period and other requirements are met. Draft legislation entitled “The Invest in Small Business Act” sponsored by Senator John Kerry (D-MA) and co-sponsored by Senator Robert Menendez (D–NJ) would improve on the House Bill by shortening the holding period from five to four years and extending the 100 percent gain exclusion to stock acquired before January 1, 2011, and on or after January 1, 2010, rather than after March 15, 2010. The Senate Finance Committee is expected to mark up a small business package in the coming weeks and it is anticipated that the 100 percent capital gains exclusion for QSB stock could be signed into law by August 2010.

With the impending sunset of the 15 percent capital gains rate at the end of 2010, and particularly if the recently passed House Bill becomes law, this sometimes overlooked provision of the Internal Revenue Code will have added attraction to U.S. individual investors, including investors accessing investments through private equity and venture capital funds and other flow-through entities. Of course, the prospect of these changes itself could have a bearing on the approach to transactions currently under consideration.