Proper Planning of Investments In Start-up Businesses May Eliminate Cincinnati Tax on Gains

Proper Planning of Investments In Start-Up Businesses May Eliminate Tax on Gains.

Investors in new start-up businesses should consider the benefits of a provision in the Small Business Jobs act of 2010 which eliminates the tax on gains on the sale of Qualified Small Business (QSB) stock issued between September 27, 2010 and December 31, 2010 and held for more than 5 years.

The act modifies Section 1202, which is a tax provision intended to stimulate cash flow into new start-up companies by reducing the taxes on future gains. The provision was originally enacted in 1993 and excluded 50% of gains on Qualified Small business Stock. The exclusion was increased to 75% for stock acquired after February 17, 2009 and was increased to 100% for stock issued between September 27, 2010 and December 31, 2010.

Qualified Small Business Stock Defined

Qualified Small Business Stock is common or preferred stock which meets the following requirements:

  • Is stock in a domestic C corporation.
  • Is acquired by the investor at original issue. The original issuance requirement is designed to encourage inflows of new capital into businesses. The stock may be acquired through the exercise of an option, warrant, or conversion of convertible debt.
  • Is acquired in exchange for money, property (except stock) or services.
  • The corporation has aggregate gross assets of less than $50 million or less at all times prior to date of issue.
  • At least 80% of the value of the corporation’s assets is used in the active conduct of one or more qualified trades or businesses.

A Qualified Trade or Business means any business other than:

  • Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more employees.
  • Banking, insurance, financing, leasing, investing or similar business.
  • Any farming business (including raising or harvesting trees).
  • Any mining or mineral extraction business.
  • Any business of operating a hotel, motel, restaurant or similar business.

The amount of gain that can be excluded from gross income under Section 1202 for any particular corporation over a taxpayer’s lifetime is limited to the greater of $10,000,000 or 10 times the adjusted basis of the stock.

In order to take full advantage of this provision investors should acquire the shares in a QSB before December 31, 2010. On January 1, 2011 the exclusion percentage goes down to 75%. Likewise holders of convertible debt or vested options in a QSB should consider exercising before year end.

In addition entrepreneurs seeking financing prior to January 1, 2011 should consider operating as a C corporation in order that investors may take advantage of this provision.