Tax Relief Act of 2010 Potentially Eliminates Federal Taxation of Gains on Investments in Qualified Small Business Stock Made in 2011

January 11, 2011 By Joseph B. Miller

A recent change to the tax laws potentially eliminates federal capital gains tax on certain investments made on or prior to December 31, 2011 in "qualified small business stock". This means that gains on qualified small business stock issued by C-corporations this year and held by a taxpayer for at least five years may be exempt from federal taxation. In order to take advantage of this tax treatment, small business owners seeking additional capital should consider organizing new ventures—or reorganizing existing ventures—as C-corporations rather than as limited liability companies or similar pass-through entities. 

The Small Business Jobs and Credit Act of 2010 was signed into law on September 27, 2010, and included a provision amending Section 1202 of the Internal Revenue Code to permit the exclusion of 100% of any gain realized on the sale of qualified small business stock acquired between September 28, 2010 and December 31, 2010. This provision had not been widely anticipated, however, and its December 31, 2010 expiration proved to be too short a window for many investors to identify qualifying new investment opportunities and consummate those transactions. The Tax Relief Act of 2010, which passed on December 17, 2010, extends the 100% exclusion provided in the Small Business Jobs and Credit Act of 2010 to qualified small business stock acquired through December 31, 2011. 

Under Section 1202, "qualified small business stock" is stock issued by a domestic C-corporation that meets certain requirements, most significantly that the corporation's total gross assets have not exceeded $50 million prior to issuance of the stock and that at least 80 percent of the corporation's assets are used in the active conduct of a trade or business (other than certain excluded activities, such as banking or investing, farming, mining, operating restaurants or hotels, or operating a professional services firm). Various other restrictions apply, including strict limitations on redemptions of the stock for certain periods before and after its issuance.

In order to qualify for preferential treatment under Section 1202, qualified small business stock must be held by the investor for at least five years. If the investment is sold in connection with a tax-free reorganization within the five year window, the gain on the original investment will qualify for Section 1202 treatment if the subsequent investment is held to the end of the five year period. The amount of gain that can be excluded by an investor with respect to a particular issuer is limited to the greater of:  (i) $10 million, or (ii) ten times the investor's aggregate adjusted basis in the qualified small business stock. Significantly, the Tax Relief Act of 2010 provides that the excluded gain is not treated as an item of tax preference for alternative minimum tax (AMT) purposes.

Under Section 1202, an individual can make an investment in qualified small business stock directly or through a pass-through investment entity such as a limited partnership or limited liability company. 

For more information regarding Section 1202's tax benefits, please contact Joe Miller, Bill Strench, Scott Dolson, or any other lawyer in Frost Brown Todd's Entrepreneurial Business and Venture Capital Practice Group.