Stuff Those Stockings With Small Business Stock!

Under current US tax law there is a 100% exclusion from federal tax for any capital gains realized from certain investments in “qualified small business stock” made before December 31, 2013 (and such gains are also excluded for purposes of the alternative minimum tax).  The closing, then, of a particularly tax-advantaged window to make investments looms near.

The New Year will bring an increase of 20% in the federal tax rate for many investments – up from a rate of 0% for qualifying investments made on or before December 31, 2013 (yes, that means no federal tax).  You should consider taking advantage of the current exclusion from capital gains taxes before it expires.  And the holiday cheer offered by this potential tax benefit is not limited to outside investors.  Others who may want to consider a change in their end-of-year financial plans include:

(1)   Entrepreneurs – if you were thinking about forming a company or contributing additional capital to your new business at the beginning of 2011, you may want to accelerate your plans.

(2)   Option/warrant holders – if you hold vested options/warrants, you may want to evaluate an early exercise of your rights.

(3)   LLC members – have you been considering a change in form of entity?  Conversion to a corporate form before the end of the year could qualify the stock you receive for tax free treatment on capital gains.

Section 1202 of the Internal Revenue Code includes a number of requirements and limitations for this tax benefit, some of which are summarized below.  As the list below is not exhaustive, you should review the details of any proposed investment with an attorney or tax adviser to ensure that it qualifies.

(1)   The issuer must be a C corporation.

(2)   The stock must be acquired at original issuance from the issuer (not from a third party or secondary offering).

(3)   The stock must be held for at least five years.

(4)   The aggregate gross assets of the issuer (including majority parents and majority-owned subsidiaries) may not exceed $50 million at issuance.

(5)   The issuer must engage in the active conduct of a “qualified trade or business.”  Examples of businesses that do not qualify include: banking, insurance, financing, leasing, investing, farming, mineral extraction, hospitality businesses, and a variety of service businesses where the principal asset of such trade or business is the reputation or skill of its employees (such as those in health, law, consulting, and financial services).

(6)   The tax exclusion applies to the greater of the first $10 million in gain and ten times the taxpayer’s basis in the stock.

Note:  This content is provided solely for general informational purposes.  It does not constitute legal advice regarding any specific facts and circumstances, and its dissemination does not create an attorney-client relationship.   If you are interested in learning more or want to discuss a particular situation, you should contact one of us or another attorney or tax adviser.