What if you could tell your potential investor that if they choose to invest in your company, the government will exclude the entire gain on sale from tax? Through the end of 2011, this statement may be true for your company! Since 1993, the IRS has allowed a portion of gain related to the sale of a qualified small business stock to be excluded from tax and The Small Business Jobs Act of 2010 (extended through 2011 by the Tax Relief Act of 2010) increased the exclusion to 100% for stock acquired by December 31, 2011.
Does my company qualify? This special exclusion is for investments in qualified small business stock that meet the following specifications:
- Domestic C corporation (S corporations do not qualify)
- Qualifying type of business (examples of businesses not included are financial institutions, farms, professional service firms, hotels and restaurants)
- Aggregate gross assets do not exceed $50 million at any time after August 9, 1993 and before the investment or immediately afterward.
- At least 80% of the company's assets must be used in the "active conduct" of the business. For example, research is deemed as active conduct; however, rental of real property is not.
What investors does this target and what do they need to know? Individuals, trusts, partnerships and LLC's can qualify for stock holdings with the following profile:
A. Investors must acquire the stock as an original issue in exchange for money, property or as payment for services directly from the corporation.
B. The investor must hold the stock for at least 5 years. For example, if the investor purchases the stock on November 15, 2011 and sells before November 15, 2016, the entire gain on salewould be subject to capital gains tax. However, if held until November 16, 2016, the entire gain would be tax free.
C. There are limitations to the exclusion for highly-successful investors. The exclusion of gain is restricted in any tax year to the greater of:
- $10 million (or $5 million if you are married filing separately). You must reduce this $10 million by gain excluded in prior years for the same corporation; or
- 10 times the adjusted basis of the stock sold during the current tax year
And unlike other provisions, the benefit is available to those subject to the alternative minimum tax (AMT)! But only for purchases through the end of 2011, after that time, the benefit is not available to taxpayers in AMT.
Example of the benefit: An investor, we'll call him Joe, has the choice of purchasing 1,000 shares of A Company stock or 1,000 shares of B Company stock for $100,000. A Company is a qualified small business and B Company is not. Let's assume the capital gains tax is 15% and that both the companies' stock will appreciate identically. If Joe purchases A Company stock on 11/15/2011 and sells it on 12/15/2016 for $200,000 he would have a $100,000 gain that is not subject to tax, leaving him with a $100,000 return on his investment. If Joe had decided to purchase B Company instead and sold on the same day he would have a $100,000 gain that is subject to a 15% tax. This means his return would only be $85,000 [$100,000 - ($100,000 X 15%)]. As you can see, with a few extra zeros behind these numbers and as the tax rate increases, your investor could benefit substantially. The 15% capital gains rate in 2016 assumes that the rate has not changed between now and then.
Other important considerations: Although the 100% exclusion is only good for purchases made in 2011, investors that do not purchase until 2012 will still benefit from a 50% exclusion for regular tax (not AMT). And while it is possible that Congress could extend the 100% exclusion to 2012, now is the time to get the word out before another company gets your capital!
Disclaimer: This blog is for informational purposes only. The nature of the information is intended to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that if tax advice or other expert assistance is required, the services of competent professional person should be obtained.
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