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Lock in tax breaks for small business stock

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If you run a small business or own stock in an up-and-coming company, you may be in line for two little-known tax breaks. These tax goodies are only available to owners of qualified small business stock (QSBS).

Strategy: Make a timely election on your tax return for either tax break. According to a new private ruling, you won’t be penalized if the oversight isn’t your fault. Otherwise, you run the risk of losing the tax benefits … probably forever.

First, let’s take a quick look at the rules.

Tax break No. 1: As long as you meet certain requirements, you can exclude capital gains tax on up to 50 percent of your gain from the sale of QSBS. For this particular tax break, you must have held the stock for at least five years. Also, the stock must have been directly issued to you or given to you by someone who received the original- issue shares.

But there’s a catch: The capital gains tax for QSBS is 28 percent. Since you’re paying tax on only half of the gain, the effective tax rate is 14 percent (50 percent of 28 percent). In contrast, the normal tax rate for long-term capital gain (i.e., gain on stock held more than a year) is 15 percent— or just one percent higher.

That means most stockholders may prefer to use …

Tax break No. 2: This tax break allows you to defer any current tax on gains from QSBS if you roll over the sales proceeds into new QSBS shares within 60 days. The tax break is available for QSBS held more than six months. If you reinvest less than 100 percent of the proceeds, you’re taxed on gains up to the difference between the sales proceeds and the amount reinvested.

Your holding period for the new stock dates back to the purchase of the original stock. In effect, you’re able to get cash out of the QSBS with no tax while you hang on to the tax exclusion for an even bigger payday.

This rollover break must be elected by your tax-return due date for the year of the sale (plus any extensions). If your return was filed by the unextended due date, you can elect tax deferral on an amended return filed within six months.

In the new private ruling, the taxpayer wasn’t aware of the rollover tax break. Since the omission was the fault of his professional tax return preparer, the IRS approved the taxpayer ’s tardy election. (IRS LR 200604004) But you might not be as fortunate, so hit the deadline.

Logistics: Report the entire gain on Schedule D (Capital Gains and Losses). Directly below the line for the gain, enter in column (a), Section 1045 rollover, and put the postponed amount in column (f). That way, you pay tax only on the net of the two amounts, which is zero if you roll over all the proceeds.

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