New Tax Benefits for Investing in Small Businesses

The global economic meltdown has caused investors to take a
new look at investing in private companies and the tax breaks that might arise
from such investments. The recently enacted federal stimulus package contains
such a tax break, excluding 75 percent of the gain on the sale of shares of
certain companies from federal taxation. This tax break serves to encourage
investment in startup companies that would normally have difficulties enticing
capital investment.

Section 1241(a) of the American Recovery and Reinvestment
Act of 2009 amended Section 1202(a)(3) of the Internal Revenue Code so that 75
percent of the gain on Qualified Small Business Stock (QSBS) held for more than
five years is excluded in determining taxable income. As a result, gain from
the sale of QSBS to which the 75 percent gain exclusion applies is taxed at
effective rates of 7 percent on the regular income tax and 12.88 percent under
the alternative minimum tax regime.

Who might be interested in this tax break for investments in
small businesses? First, company founders and entrepreneurs who use their own
capital to establish companies and develop new products and technologies. The
return on their efforts and risk taking will be enhanced by lower tax rates.
Second, QSBS would be of interest to investors in a startup business because of
the potential to provide a greater after-tax return when the investment in a
successful company is cashed out. Corporate investors are not eligible for the
QSBS exclusion.

In order to qualify for the 75 percent exclusion, the QSBS
must be acquired after Feb. 17, 2009, and before Jan. 1, 2011. For shares
acquired before or after these time periods, the gain exclusion is 50 percent
or 60 percent depending upon certain other criteria.

QSBS is defined in Section 1202(c) as stock that meets the
following conditions:

1. issued by a domestic C corporation after Aug. 10, 1993;
2. acquired by the shareholder directly from the company;
3. acquired by an individual in exchange for cash, services
   or property other than securities;
4. the issuing corporation has gross assets not exceeding
   $50 million at the time the investment is made; and
5. the corporation uses at least 80 percent of its assets in
   the active conduct of one or more qualified trades or businesses.

There are some exceptions to the requirement that QSBS be
acquired directly from the company. Gifts, transfers at death, transfers from a
partnership, corporate organizations, stock conversions, options, warrants or convertible
debt provide exceptions to the original issue requirement.

At least 80 percent of the corporations assets must be used
in the active conduct of a qualified trade or business. Consequently, QSBS
benefits are principally available for manufacturing, technology, retail,
distribution and similar businesses. A qualified trade or business excludes
services in the fields of health, law, engineering, architecture, accounting,
actuarial science, performing arts, consulting, athletes, financial services, brokerage
services, farming business, oil and gas production, and any business of
operating a hotel, motel, restaurant or similar business.

The exclusion for each eligible corporation applies only to
the extent that the gain does not exceed the greater of (a) 10 times the
taxpayers adjusted basis in the stock disposed of during the tax year or (b)
$10 million ($5 million for married individuals filing separately) reduced by
gain excluded in earlier years from sales of stock in the corporation.

While QSBS status can provide a significant tax benefit when
a shareholder sells shares, a prudent investor will consider the various tax
forms for entities when analyzing a potential investment. Use of pass-through
entities such as partnerships, limited liability companies or S corporations
can provide beneficial tax results to an owner. The investment risks and tax costs of a successful
investment are among the factors to be considered when investing in a privately
held company.

This is a legal sponsored report from Lane Powell PC. Gary P. Tober, a shareholder at Lane Powell and
chair of the firms Tax Practice Group, focuses his practice on tax and business
planning for United States and foreign corporations, partnerships and
individuals. He emphasizes the tax aspect of business formations,
operations and investment transactions in addition to advising on business and
legal aspects of such transactions. He can be reached at [email protected]
or (206) 223-7984.