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A heavenly break for small business: QSBS investors

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in Small Business Tax,Small Business Tax Deduction Strategies

Do you need an “angel” to help your business fly? An expiring tax law provision may give you the wings.

Strategy: Offer qualified small business stock (QSBS) to investors. As long as your company meets certain requirements, an investor may be able to exclude up to 100% of the capital gain from a subsequent sale of the stock. That’s not a misprint—the gain is completely tax-free!

Initially, this unique tax break was scheduled to expire after 2010, but it was extended for another year. As things stand now, the 100% exclusion only applies to QSBS acquired before 2012. It appears unlikely that it will be extended again.

If you don’t require outside financing from a business angel, you can ante up and later claim the tax break for yourself. Either way, your business benefits from a much-needed infusion of cash.  

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 (see box below).

But there was a big catch: The maximum federal tax rate on the 50% taxable portion of QSBS gains was 28%, which equated to an effective rate of 14% (50% of 28%). That is only a percentage point better than the 15% maximum rate on gains from selling garden-variety stock held for more than a year.

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 increased to 100% for QSBS shares issued between Sept. 28, 2010, and Dec. 31, 2010. In addition, the new law eliminated AMT complications for gain resulting from the sale of QSBS during this time period.

The 100% exclusion was subsequently extended to cover QSBS issued through Dec. 31, 2011, by the 2010 Tax Relief Act.

Barring any last-minute tax law changes, the window of opportunity is slamming shut in a few months. And the lure of this future tax exclusion is even stronger if the capital gains rate increases after 2012 as currently scheduled. Caveat: Don’t ignore potential state income tax aspects.

Key point: The 100% gain exclusion deal is only available if you hold the QSBS for more than five years.

Tip: No current tax is due on a gain from the sale of QSBS if the investor rolls over the proceeds into new QSBS within 60 days.

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