New Legislation Eliminates Capital Gains Tax for Certain New Investments in Small Businesses Made Before January 1, 2011
On September 27, 2010, President Obama signed into law the Creating Small Business Jobs Act of 2010 (the “Act”). Among other provisions, the Act excludes from gross income for regular income and alternative minimum tax purposes 100% of the capital gains (subject to a per issuer limitation described below) of non-corporate taxpayers from investments in qualified small business stock made after September 27, 2010 and before January 1, 2011. For investments in qualified small business stock made after December 31, 2010, only 50% of the capital gains generally will be excluded from gross income. However, in most situations, these capital gains will be taxed at an effective rate equal to the 20% expected long-term capital gains rate as a result of the higher capital gains tax rate applicable to the non-excluded portion of the capital gain and the application of the alternative minimum tax, effectively eliminating the benefit of the exclusion.
To qualify for the 100% exclusion (in addition to completing the acquisition after September 27, 2010 and before January 1, 2011), all of the limitations applicable to investments in qualified small businesses must be met, including, among other requirements:
- The stock must be held for more than 5 years (subject to certain exceptions for qualifying tax-free “rollovers”);
- The exclusion applies only to non-corporate taxpayers;
- The small business must be a domestic C corporation and the stock purchased must be purchased by the investor as an original issuance from the corporation (directly or through an underwriter);
- The small business generally must use 80% of its assets (by value) in a qualifying active business (which excludes certain types of businesses, such as financial institutions, farms, professional service firms, hotels and restaurants and similar businesses) for substantially all of the investor’s holding period;
- The small business must not have made certain redemptions of its stock prior to or following the acquisition of the stock; and
- The aggregate gross assets (defined generally as cash plus the aggregate adjusted tax basis of other property) held by the small business must not exceed $50,000,000 at any time before or immediately following the investment by the investor (including amounts received by the small business from the investor).
In addition, there is a per issuer limit on gains eligible for the exclusion equal to the greater of $10,000,000 or 10 times the adjusted tax basis of stock issued by the small business and disposed of by the investor during a particular year.
The temporary exemption from regular income and alternative minimum tax of capital gains from investments in qualified small business stock presents a significant opportunity for investors who are considering making an investment in a qualifying small business, and who are able to do so before the clock strikes midnight on December 31, 2010.
Additionally, companies that are just being formed, or are currently not structured as a domestic C corporation (such as limited liability companies), should consider whether being formed as, or converting to, a domestic C corporation could permit equity holders of the company to benefit from the 100% exclusion. Note, however, that with respect to S corporations and other non-eligible corporate entities, a conversion of the corporation to a domestic C corporation generally would not enable the current stockholders of the corporation to qualify for the 100% exclusion with respect to any stock that they currently hold.
© 2010 Perkins Coie LLP