Tax Breaks on Small Business Stock

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It's not often that the IRS gives tax breaks that benefit you whether you make money or lose it. But such is the case with small business stocks.

-You can generally exclude up to 50 percent of your gains on sales of small business stocks if you have held them for over five years.

-You can roll over your gains from the sale of small business stocks if you used the money to purchase other qualifying small business stocks.

-You can deduct ordinary losses on the sale of qualifying small business stock.

Gains on the Sale of Small Business Stock
Rollover of Gains on the Sale of Small Business Stock
Losses on the Sale of Small Business Stock

In order to stimulate investment in small businesses, the 1993 tax law introduced code Section 1202, which says that you may exclude from taxable income up to 50 percent of the gain you realize on the sale of qualified small business stock.

In order to qualify for the exclusion, you must meet these criteria:

• You are not a corporation.

• You acquired the stock from a C corporation after August 10, 1993, in an original issue, in exchange for money or other property, or as compensation for services that were provided to the corporation.

• On the date the stock was issued, the corporation was a qualified small business.

• During substantially all the time the stock is held, the business meets the active business requirements of Section 1202 (c). This requirement will be waived if the corporation qualifies as a specialized small business investment company.

• At all times after August 10, 1993, or after the inception of the company if later, and immediately after the issuance, the corporation's gross assets do not exceed $50 million.

• At least 80 percent of the assets of the corporation are used by the corporation in the conduct of one or more qualified trades or businesses. A qualified business means any trade or business other than:
  • Any trade or business involving the performance of personal services in specified fields such as accounting, law, or medicine.

  • Any business involved in banking, financing, leasing, insurance, or similar businesses.

  • Any farming business.

  • Any business operating a hotel, motel, restaurant, or similar business.

  • Any business to which a deduction for depletion is allowed.
• The corporation must be an eligible C corporation, which precludes a number of specialized corporations such as REITs, REMICs, DISCs, and cooperatives.

• The corporation must not have purchased stock from you within two years before or after issuing stock to you. It cannot have purchased stock of greater than five percent of total stock outstanding from anyone within one year before or after issuing stock to you.

If the corporation is an Empowerment Zone Business the exclusion is increased to 60 percent.

Limits on the Amount of Gain You Can Exclude

For any corporation's stock, the maximum gain eligible for exclusion in any one year is $10 million, less any gains excluded in previous years. Therefore, the maximum lifetime exclusion for any one issuer's stock is $5 million, or 50 percent of $10 million ($6 million if the corporation is an Empowerment Zone Business).

In addition, you are limited to a gain that is not more than 10 times the adjusted basis of the stock.

The nonexcluded portion of the gain on sale is subject to tax at 28 percent (resulting in an effective rate of 14 percent (50 percent of 28 percent)) on the entire gain.

Also, seven percent of the excluded gain is a preference item for purposes of calculating Alternative Minimum Tax (AMT). A preference item is an item of income that is added back to your regular income for purposes of computing the AMT, a parallel taxing system designed to make sure that higher income taxpayers pay at least a minimum amount of tax.

As you can tell, there are a number of hurdles to overcome in order to exclude the gain. However, if you think you might qualify, or want to structure your investment to make sure you qualify, you should consult a professional advisor with expertise in this area.

Rollover of Gains on the Sale of Small Business Stock

If you hold small business stock for more than six months, then sell the stock at a gain, you may defer (or roll over) the gain by reinvesting the proceeds within 60 days into new small business stock. The rolled-over gain will reduce the basis of the new stock. And any amounts not rolled over will be subject to tax to the extent of the gain realized.

In order to qualify, the old and the new stocks must meet the Section 1202 definition of small business stock. In addition, the new stock must meet the active business requirement for the six-month period following its purchase. If all of the requirements are met, the holding period of the new stock, for all purposes except the six-month active business test, will include the holding period of the old stock.

Losses on the Sale of Small Business Stock

According to statistics published by the American Bankruptcy Institute, there were an average of 59,765 business bankruptcies per year in the United States between 1980 and 2000.

As a result, a lot of people have lost most, if not all, of their invested capital. Under the tax code, you are only allowed to deduct $3,000 of net capital losses each year. But there is an exception to these very limiting rules under Internal Revenue Code Section 1244. This section offers relief to individuals who suffer capital losses when they sell stock of a qualifying small business.

Under Section 1244, losses that would otherwise be treated as capital losses are treated as ordinary losses. This has several advantages to the individual:

1. Ordinary losses are not limited to $3,000 per year. Your ordinary losses can be fully deducted in the year of the loss.

2. Ordinary losses are not netted with capital gains that are subject to a maximum tax rate of 20 percent. Therefore, if you have capital gains in the same year you have ordinary losses, you can still enjoy the capital gains rates.

3. Ordinary losses offset other sources of income that is taxed at ordinary rates, which, can be as high as 35 percent. The maximum Section 1244 loss that can be taken in any year is:

$100,000 for married individuals filing a joint return.

$50,000 for all others.

How to Qualify as a Small Business Stock

To qualify as a Section 1244 small business stock, there are several requirements that must be met:

• The stock must come from a domestic corporation. Only stock (including preferred stock) of a domestic corporation can qualify as Section 1244 stock. If the stock was issued prior to July 19, 1994, the stock must be common stock.

• The company must be small. Capital receipts of the company can't be over $1 million, including the value of any stock previously issued. If the capital received exceeds $1 million, the corporation must designate which shares are considered Section 1244 stocks. If, in the year of issue, the capital received goes over the $1 million mark, and the company fails to designate the stock within the required time period, the IRS regulations specify how to allocate the loss between 1244 stock and non-1244 stock.

• You must have paid for the stock with money or other property. The stock issued must be issued in exchange for cash or other property. Stock issued in exchange for other stock or for services rendered doesn't qualify. Also, special rules apply to the valuation and treatment of property that was exchanged for the stock. If you contribute property to the corporation, you should familiarize yourself with these rules.

• Most of the company's gross receipts must be from operations. For the period of the corporation's most recent five years ending before the date of the loss, gross receipts from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities must not exceed 50 percent of the receipts of the company. (If the company has been in business less than five years, the testing period applies to all the years the company has been in existence.) This gross receipts test does not apply, however, if during the applicable period, the aggregated amount of deductions exceeds the aggregate amount of gross income. To have this exception apply, the company must be an operating company; it can't be an investment company.

• As owner of the Section 1244 stock, you must be an individual or a partner in a partnership that holds 1244 stock.

• You must have acquired the stock after June 30, 1958.

• If the stock was acquired before November 7, 1978, the stock must have been issued under a written plan that met the requirements of Section 1244.

• You must have held the stock continually as an individual or partnership since the date the stock was issued.