Tax-Free Opportunity for Investments in Small Businesses

Tax-Free Opportunity for Investments in Small Businesses

In late September of this year, the federal government passed the Small Business Jobs Act of 2010 (“SBJA 2010”). Among other things, SBJA 2010 provides for an exclusion of 100% of the gain realized on the sale of certain qualified small business stock (“QSBS”) held for at least five years, if such QSBS is acquired or issued between September 27, 2010 and January 1, 2011.


QSBS, subject to a few exceptions, means stock in a domestic corporation if: (1) such corporation is a “qualified small business” (“QSB”) at the time the stock is issued; and (2) the taxpayer acquires the stock, in an original issuance of such stock, in exchange for money, other property, or as compensation for services to the issuing corporation. In general, a QSB is a domestic C corporation, with $50 million or less in gross assets (without regard to liabilities) that is engaged in an “active business” (i.e. cannot be an investment company).

Existing Section 1202 of the Internal Revenue Code of 1986, as amended (the “Code”) permits taxpayers, other than corporations, to elect to exclude 50% of the gain realized from the sale of QSBS held for at least five years (with such exclusion subject to a cap). In certain cases involving Empowerment Zones, the exclusion is increased to 60%, and for QSBS acquired or issued between February 17, 2009 and September 28, 2010, the federal government increased the exclusion to 75%. In the past, taxpayers pursuing the QSBS exclusion were unable to realize any significant benefit because the amount excluded was treated as a tax preference for alternative minimum tax (“AMT”) purposes. Essentially, a taxpayer subject to AMT would end up with nearly the same tax liability, regardless of such taxpayer’s election to exclude gain under Section 1202.
The Section 1202 exclusion for a taxpayer is limited to greater of (i) $10 million or (ii) 10 times such taxpayer’s basis in the QSBS.

SBJA 2010 not only increases the Section 1202 gain exclusion to 100%, but removes the excluded gain from the list of AMT tax preference items. Therefore, a taxpayer electing for exclusion under Section 1202 will have a zero federal tax liability with respect to the sale of QSBS held for at least five years, if such QSBS is acquired or issued between September 27, 2010 and January 1, 2011. Tax-free gain is a rare opportunity for taxpayers in the United States; and before you know it, this opportunity will be gone.

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Roger Royse

Roger Royse, the founder of the Royse Law Firm, works with companies ranging from newly formed tech startups to publicly traded multinationals in a variety of industries. Roger regularly advises on complex tax structuring, high stakes business negotiations and large international financial transactions. Practicing business and tax law since 1984, Roger’s background includes work with prominent San Francisco Bay area law firms, as well as Milbank, Tweed, Hadley and McCloy in New York City.
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