New Tax Laws Permit Zero-Percent Tax Rate for Gains From Qualified Small Business Stock — But Only for Purchases Made During the Fourth Quarter of 2010

25 October 2010 Publication

Legal News Alert: Taxation

On September 27, 2010, President Obama signed into law the Small Business Jobs and Credit Act of 2010 (SBJA). The SBJA contains several provisions that are designed to encourage new investment in “small” businesses. One of the more significant tax provisions included in the SBJA is the application of a zero-percent federal tax rate for gains recognized by non-corporate investors from the sale of qualified small business stock (QSBS) that has been held for more than five years, but only if the stock is purchased after September 27, 2010 and before January 1, 2011. Importantly, the zero-percent tax rate applies for purposes of both the regular federal income tax and the alternative minimum tax. This is a significant departure from current law, which provided for only a very small reduction in federal tax rates gains from QSBS (such reduction being increased somewhat for QSBS purchased in 2009 or 2010) and which also included such tax benefits as a preference item for purposes of the alternative minimum tax.

Under the new provision, as under current law, a number of requirements must be satisfied in order to qualify for the zero-percent tax rate, including the following:

  • The investor must not be a corporation and must hold the stock for more than five years
  • Subject to certain exceptions, the investor must acquire the stock at original issuance, generally for money or other property (not including stock)
  • The issuing corporation must be a domestic C corporation
  • The issuing corporation must be a “qualified small business” on the date the QSBS is issued, which generally requires, among other things, that the corporation’s gross assets must be $50 million or less (generally measured by tax basis in the corporation’s assets) immediately after the issuance and at all times since August 10, 1993
  • For substantially all of the investor’s holding period, the issuer must be engaged in a “qualified trade or business” or certain research and experimental activities
  • The issuing corporation must not have engaged in significant redemptions at certain times before and after the issuance

As under prior law, the aggregate amount of gain for any taxpayer with respect to an investment in a single issuer that may qualify for the zero-percent tax rate is generally limited to the greater of $10 million or 10 times the investor’s aggregate tax basis in the issuer’s QSBS. For a taxpayer who invests cash in QSBS, the “tax basis” would generally be equal to the taxpayer’s cash purchase price. However, a special rule is provided for purposes of this provision in cases where a taxpayer purchases QSBS for property other than cash. In such cases, the taxpayer’s basis in the QSBS, solely for purposes of these special rules, is deemed to be the fair market value of the property transferred for such QSBS.

A few examples might help illustrate how this special rule works:

Example #1: Assume that a taxpayer owns valuable intellectual property (or other assets) that has a tax basis of zero and a fair market value of $1 million. If the taxpayer transfers the IP (or other assets) to a corporation in exchange for QSBS in a transaction qualifying as tax-deferred under Section 351 or other provisions of the Code, the taxpayer’s “starting point” for purposes of these rules would be $1 million. That is, upon a subsequent sale of the QSBS, the taxpayer’s stock gains from $0 to $1 million would be taxable at regular tax rates (potentially long-term capital gains rates), but the taxpayer’s next $10 million of gains from the stock would potentially qualify for the new zero-percent tax rate if the applicable requirements (including the five-year holding period and so forth) are met.

Example #2: If in the same example above, the IP transferred for the QSBS had a fair market value of $3 million, then the taxpayer could potentially exclude up to $30 million of gains from the stock rather than $10 million.1 In other words, upon subsequent sale of the stock, the first $3 million of this taxpayer’s gains would be taxable at regular tax rates (potentially long-term capital gains rates), but any additional gains up to $30 million would potentially qualify for the new zero-percent tax rate.

Planning Opportunities for the Remainder of 2010

Non-corporate investors who are considering making investments in one or more C corporations in the coming months should carefully examine the requirements of Section 1202 to determine the extent to which they may apply to their particular transaction. For investments that are scheduled to close in the next few months, every effort should be made to close prior to January 1, 2011 in order to potentially qualify under the new law. The difference in tax consequences between a transaction closing on December 30, 2010 and one closing just a few days later on January 2, 2011 can be very large.

In addition, investors who are considering making current commitments to make future investments in C corporation stock might consider restructuring these commitments into current purchases of stock, possibly with put options, promissory notes, or other similar mechanisms to accommodate investment terms. Through careful structuring, such investments might obtain enhanced tax results if consummated prior to January 1, 2011.

In addition, existing operating companies that are currently formed as partnerships, or limited liability companies that are taxed as partnerships, also might consider the extent to which this new rule applies to them. For example, an existing business formed as an LLC (and taxed as a partnership) might convert into a C corporation form. The resulting issuance of stock in the C corporation to the former members of the LLC could potentially qualify as QSBS (see examples set forth above).2

Please note that the requirements of this new tax law are numerous, complex, and, in many cases, very subtle. The foregoing is merely a summary of these rules. Should you have any particular transaction to which the foregoing rules may apply, please consult your tax advisor or attorney. 


1 Again, the maximum amount of gain that can qualify under this tax benefit is, generally speaking, the “greater of” $10 million or 10 times the taxpayer’s basis in the QSBS. Under the special rule for property transfers, the taxpayer’s “basis” in the QSBS would, for this purpose, be equal to the fair market value of the property transferred by the taxpayer for the QSBS. In this example, since the fair market value of the IP is assumed to be $3 million, then 10 times that amount would be $30 million, which is greater than $10 million.

2 Of course, any decision to convert the form of an operating business from an LLC/partnership to a C corporation can have many other far-reaching tax consequences, both good and bad, each of which should be analyzed and carefully considered.


Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues.

If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or:

Peter J. Elias
San Diego, California
619.685.4613
pelias@foley.com

Internal Revenue Service regulations generally require that, for purposes of avoiding United States federal tax penalties, a taxpayer may only rely on formal written opinions meeting specific requirements described in those regulations. This newsletter does not meet those requirements. To the extent this newsletter contains written information relating to United States federal tax issues, the written information is not intended or written to be used, and a taxpayer cannot use it, for the purpose of avoiding United States federal tax penalties, and it was not written to support the promotion or marketing of any transaction or matter discussed in the newsletter.

 

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