The new American Taxpayer Relief Act (ATRA) encourages small business owners to “put their money where their mouth is” by extending a unique tax break.
Strategy: Inject additional capital into your corporation in exchange for shares of “qualified small business stock” (QSBS).
If certain requirements are met, you can exclude up to 100% of the otherwise taxable gain from a future sale of the stock. In other words, you can pocket the entire gain tax-free!
This special tax law provision may also be used to inject a cash infusion from outside investors.
Here’s the whole story: Prior to 2009, an investor could exclude capital gains tax on up to 50% of the gain from the sale of QSBS held at least five years.
The stock must have been directly issued to the owner or given to him or her by the original recipient of the shares. Other requirements apply to the stock being issued (see box).
But there was a catch: The capital gains tax for all investors in QSBS is 28%. Because a QSBS investor was taxed on half of the gain, the actual tax rate was 14% (50% of 28%). In contrast, the maximum tax rate for long-term capital gain (i.e., gain on stock held for more than a year) was 15%—or just one percentage point higher.
In addition, 7% of the excluded gain was treated as a tax preference item for alternative minimum tax (AMT) purposes. This might increase an investor’s overall tax liability.
The 2009 economic stimulus law created a temporary tax benefit for QSBS investors. It increased the maximum tax exclusion for QSBS from 50% to 75% for QSBS acquired after Feb. 17, 2009, and before Jan. 1, 2011. This effectively reduced the capital gains tax bite to just 7% (25% of 28%)—less than half of the regular capital gains tax rate.
Under the 2010 small business law, the maximum exclusion was increased to 100% for acquisitions in QSBS from Sept. 28, 2010, through Dec. 31, 2010. In addition, the law eliminated AMT complications for gain resulting from the sale of QSBS during this time period.
The 100% exclusion was subsequently extended through Dec. 31, 2011, by the 2010 Tax Relief Act.
Now ATRA extends the 100% exclusion for QSBS issued through Dec. 31, 2013. The 100% exclusion also is extended retroactive to Jan. 1, 2012. Thus, it is a two-year extension. You must hold the QSBS for more than five years to qualify for the tax-free deal.
Tip: No current tax is due on a gain from a sale of QSBS if you roll over the proceeds into new QSBS within 60 days.