On December 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “Act”).  Among other provisions, the Act extends for one additional year the exclusion 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.  The 100% exclusion will now apply to investments made after September 27, 2010 and before January 1, 2012.  For investments in qualified small business stock made after December 31, 2011, 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, therefore 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, 2012), 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 (an S corporation is ineligible)

  • The stock must be acquired at its original issuance from the corporation (directly or through an underwriter);

  • The corporation must meet certain “active business” requirements, meaning generally that it must use 80% of its assets (by value) in a qualifying active business (excluding 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 million 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 million or 10 times the adjusted tax basis of stock issued by the small business and disposed of by the investor during a particular year.

Practical Advice

Because the Act extends the window during which qualifying investments can be made, there is no longer any pressing need to close any pending transactions prior to December 31, 2010.  Investors now will have until December 31, 2011 to take advantage of the opportunity to make investments that qualify for this temporary exemption from regular income and alternative minimum tax of capital gains.

Companies that are just being formed, or that 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 the current stockholders of an S corporation or other non-eligible corporate entity that converts to a domestic C corporation generally would not be able to qualify for the 100% exclusion with respect to any stock that they currently hold.

Provided that all of the requirements are otherwise met, the exclusion may apply to a broad variety of equity, including preferred stock investments, the issuance of common stock to founders and employees, shares issued upon the conversion of convertible debt (even where the debt was issued prior to the effective date of the Act) and shares issued upon the exercise of stock options.

Otherwise eligible corporations should consult with their advisors prior to redeeming any shares, as such redemptions may prevent its shares from qualifying for the exclusion.

© 2010 Perkins Coie LLP


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