New Tax Act Reduces Capital Gain Rates to 7% on Certain Investments in Small Business

March 6, 2009

A little noticed provision in the American Recovery and Reinvestment Act of 2009 (the “Recovery Act”) presents the opportunity for purchasers of stock in certain small businesses to be eligible for a 7% capital gains rate on those investments. The rate is available to individuals who invest directly, or indirectly through venture capital or private equity funds, in “qualified small business stock” after February 17, 2009 and before January 1, 2011 and hold the investment for more than 5 years.

A “qualified small business” is a domestic C corporation whose total gross assets have not exceeded $50 million prior to the investment. To be qualified for the reduced rate, the small business must actively conduct a trade or business, and the exclusion is not available to banks, investment companies, REITs, farms, hotels, restaurants or professional services firms. In addition, the small business will lose its status as a qualified small business if certain redemptions of its stock are made within two years before or after the issuance of the stock.

The amount of excludible gain from normal capital gains rates is limited to the greater of: (i) $10 million, or (ii) 10 times the aggregate adjusted basis of the shares. In addition, a portion of the excluded gain is included in the calculation of alternative minimum taxable income.

The five year holding period commences when the stock is issued. Stock issued upon conversion of debt or exercise of a warrant is considered issued on the date of such conversion or exercise. To achieve the five year holding period, an individual may reinvest the proceeds from the sale of a qualified small business stock in the qualified small business stock of another company if the original stock was held for at least six months. In addition, if qualified small business stock is exchanged for stock in another company in a tax free exchange, the holding period will include the period during which the new stock is held (although any gain from the new stock is not eligible for the reduced capital gains rate).

We expect that this more favorable treatment under the Recovery Act will renew interest in investments in small growth businesses and may lead business owners to organize new ventures as C corporations rather than as pass-through entities (such as LLCs). The impact of this provision may become even more significant if the capital gains rate for high income taxpayers increases to 28% as currently proposed.

For more information, please contact our Entrepreneurial Business and Venture Capital Practice Group.