Temporary Exclusion of 100% of Gain on Investments made in Qualified Small Business Stock

UPDATE TO BELOW:  On December 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 which included, among other things, an extension of the tax benefit discussed below for all of 2011.  For a summary of the tax law changes, please review the following Dorsey & Whitney tax alert.

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The following is a re-print of a Dorsey & Whitney tax alert that can be found here. This benefit is only available for a very limited time, but it is quite significant for investors that can take advantage of it. Angel investors making investments in this time frame might want to consider buying equity rather than convertible debt in order to take advantage of this benefit.

This is a follow-up to my post here.

Temporary Exclusion of 100 Percent of Gain on Qualified Small Business Stock

Recently enacted legislation provides investors with a potentially significant tax benefit for qualified small business stock acquired before the end of this year. The Small Business Jobs and Credit Act of 2010 contains a number of provisions aimed at encouraging investment in small businesses. These provisions include an amendment to Section 1202 of the Internal Revenue Code of 1986, as amended (the “Code”), temporarily permitting the exclusion of 100 percent of the gain from the sale of certain “qualified small business stock” acquired after September 27, 2010 and before January 1, 2011 that is held for more than five years by a non-corporate taxpayer. The amendment also provides that the excluded amount will not be a tax preference item for purposes of calculating alternative minimum tax. As a result, the effective federal income tax rate on any capital gain from the sale of qualified small business stock that qualifies for the 100 percent exclusion will generally be zero. The amount of gain that a taxpayer may exclude with respect to stock in a particular corporation is limited to the greater of $10,000,000 or ten times the taxpayer’s adjusted basis in the qualified small business stock.

Qualified small business stock is defined as any stock of a corporation acquired at original issuance in exchange for money or other property (not including stock) or as compensation for services if the corporation is a “qualified small business” on the date of issuance of the stock. To be a qualified small business, the corporation must: (1) be a domestic C corporation; (2) have aggregate gross assets (including proceeds received in exchange for the stock) of $50,000,000 or less at all times from August 10, 1993 through the date the stock is issued; and (3) agree to submit reports with the Internal Revenue Service and its shareholders as required by the Internal Revenue Service.

Stock will not be considered to be qualified small business stock unless the corporation uses at least 80 percent (by value) of its assets in the active conduct of one or more qualified trades or businesses during substantially all of the taxpayer’s holding period for the stock. Research and start-up activities are generally considered to be a qualified trade or business, but certain other types of activities are specifically excluded, including, for example, banking, farming, and operating a hotel or restaurant. In addition, stock will not be considered to be qualified small business stock if the corporation: (1) redeems stock with an aggregate value greater than 5 percent of the aggregate value of all of its outstanding stock during the two-year period starting one year prior to the date the stock was issued; or (2) redeems more than a de minimis amount of stock from the taxpayer or a related person during the four-year period starting two years prior to the date the stock was issued. A number of other special rules apply to determine whether stock qualifies as qualified small business stock under these rules, including a requirement that the stock be held for 5 years. Investors should consult a qualified tax professional to determine whether all of the requirements are satisfied in light of the particular facts and circumstances.

For qualified small business stock acquired on or before February 17, 2009, Section 1202 generally provides that taxpayers may exclude 50 percent of the gain from the sale of such stock that has been held for more than five years. For stock acquired after February 17, 2009 and on or before September 27, 2010, the exclusion is increased to 75 percent. Unlike the temporary exclusion provided by the Small Business Jobs and Credit Act of 2010, the tax advantages of these partial exclusions are typically limited because of the effect of other special rules.