Tax planning for small business stock.

It seems like each election year (and sometimes, more frequently) a debate arises--tax simplicity versus tax incentives. Three Code provisions give preferential tax treatment to equity investments in certain small business corporations. These corporations continue to be a source of job creation and innovation. They can be publicly traded or privately held and, typically, do not have equity structures that permit S corporation elections.

These incentives were provided to individual investors to encourage equity investments and compensate investors for the risk of starting and investing in small businesses. For example, an entrepreneur can roll over capital gain without currently recognizing taxable income if he or she invests the proceeds in another qualified small business (QSB) corporation. If the investment declines in value, ordinary loss treatment is generally available; this is generally more favorable than capital loss treatment. Finally, a capital gain exclusion is provided for investors who hold their appreciated stock investment for a minimum period.

Definition

According to Sec. 1202(d),a qualified small business is a domestic C corporation with aggregate gross receipts of $50 million or less, for the period that begins with Aug. 10, 1993, and ends when the stock is issued. The corporation must "also meet the gross receipts test immediately after the stock issue, taking into account amounts received for the stock. At least 80% (by value) of the corporation's assets must be used in the active conduct of one or more businesses (generally, a manufacturing or retail business), or it must qualify as a specialized small business investment company; see Sec. 1202(c)(2). Under Sec. 1202(e),personal service activities, such as health, hw, engineering, architecture, accounting, etc., are not qualified businesses, nor are the hospitality farming, insurance, financing or mineral extraction industries.

Sec. 1045 Rollover

Under Sec. 1045(a), a noncorporate taxpayer may elect to roll over the gain from the sale of QSB stock held for more than six months at the time of sale, if he or she uses the sale proceeds to purchase other QSB stock within 60 days. The QSB issuing the replacement stock must meet the active business requirement for the six-month period following its purchase. According to Sec. 1045(b)(4), the replacement stock's holding period includes the holding period of the stock sold. The taxpayer can elect Sec. 1045 for all or a portion of the shares held.

Sec. 1045(a) provides that gain is recognized only to the extent that the amount realized on sale exceeds the cost of the replacement stock purchased during the 60-day period, as reduced by the portion of such cost (if any) previously taken into account. To the extent that capital gain is not recognized, Sec. 1045(b)(3) states that the deferred gain will reduce the basis of the replacement QSB stock. The basis adjustment is applied to the replacement stock in the order such stock is acquired. The election is made by reporting the sale on Schedule D and following Rev. Proc. 9848.

Example 1: Individual N acquired QSB stock on July 1, 2003, for $100,000. On Feb. 15, 2004, she sold the stock for $150,000, a $50,000 gain. On April 1, 2004, N purchased QSB stock for $140,000 and timely elects Sec. 1045 treatment. Thus, she recognizes only $10,000 gain ($150,000-$140,000). Her basis in the replacement QSB stock is $100,000 ($140,000 purchase price -$40,000 gain deferral).

See. 1202 Gain Exclusion

For taxpayers other than corporations, Sec. 1202(a)(1) excludes from gross income 50% of the gain recognized on the sale or exchange of QSB stock issued after Aug. 10, 1993, and held for more than five years. The exclusion is 60% for QSB stock acquired after Dec. 21, 2000, in empowerment-zone businesses (as defined in Sec. 1397C(b)).

Under Sec. 1202(b), gain excludible in any tax year is limited to 50% (or 60%) of the greater of (1) $10 million ($5 million if married filing separately), reduced by the gain taken into account in earlier years; or (2) 10 times the taxpayer's basis in the stock. Both limits are applied on a per-taxpayer, per-issuer basis.

Example 2: Hand W, married filing jointly, Own QSB stock in three different corporations. Together, the spouses can exclude at least $15 million of gain ($10 million x 3 x 50%).

Sec; 1202 was enacted in 1993, before the maximum long-term capital gain rate for noncorporate taxpayers was reduced in 2003 to 15% (5% for taxpayers in the 15% bracket). However, taxpayers are not entitled to exclude both 50% (or 60%) of the Sec. 1202 gain and to apply the 15%/5% tax rates to the balance. Thus, if the QSB stock is a long-term capital asset and the taxpayer is in the 25% tax bracket or higher, the effective tax rate for gain on the QSB stock is 14% (50% x 28% capital gain rate), which is only 1% lower than the current maximum 15% capital gain rate. To further mitigate Sec. 1202, 7% of the excluded part of the gain is a tax preference for the alternative minimum tax (AMT), according to Sec. 57(a)(7). As a result, Sec. 1202 is largely ineffective today, due to the capital gain rate incentives enacted by the Jobs and Growth Tax Relief and Reconciliation Act of 2003 and the omnipresent AMT.

Example 3: If taxpayer P sells QSB stock for a $100,000 gain and excludes 50% of it under Sec. i202(a), the amount subject to AMT is 53.5% of the total gain, computed as follows:

Total gain                      $100,000
Less: Sec. 1202 exclusion        (50,000)
Plus: 7% tax preference            3.500
Gain subject to AMT              $53.500

Sec. 1244 Ordinary Loss Treatment

Sec. 1244 allows ordinary loss treatment to individuals (directly or through partnerships) who recognize a loss on Sec. 1244 stock originally issued in exchange for money or property by a domestic small business corporation. In any single tax year, an individual may treat up to $50,000 ($100,000 if married filing jointly) as an ordinary loss under Sec. 1244.

Example 4: Single taxpayer B invested $80,000 in a domestic small business corporation in June 2003. B sells his stock in October 2004 for $10,000, realizing a $70,000 loss. Ordinarily; such a loss would be treated as a long-term capital loss. However, Sec. 1244 permits B to treat $50,000 as an ordinary loss; the $20,000 balance is a a capital loss.

A sale of stock qualifies for ordinary loss treatment under Sec. 1244 only if the stock sold is Sec. 1244 stock (not QSB stock). In general, to qualify as Sec. 1244 stock, five requirements under Sec. 1244(c)(1) must be met:

1. The stock may be common or preferred stock (but, if issued before July 14, 1984, it must be common stock).

2. The issuer most be a domestic corporation.

3. The issuer must be a small business corporation, as defined in Sec. 1244(c)(3).

4. The stock must be issued for money or property (other than stock or securities).

5. At the time the loss is sustained, at least 50% of the corporation's gross receipts must have been from an active trade or business for the five most recent tax years ending before the date on which the stock loss was sustained.

Note: Only original individual shareholders who received the first $1 million of stock issued are eligible for the ordinary loss treatment. There is no holding period requirement to claim an ordinary loss.

Recent Developments

In July 2004, Treasury issued Prop. Regs. Sec. 1.1045-1 (REG-150562-03), which provides guidance for (1) sales and purchases of interests in a partnership that owns QSB stock, (2) contributions of QSB stock and (3) partnership dispositions and distributions of QSB stock. According to the proposed regulation's preamble, the partners and partnerships seeking to elect Sec. 1045 treatment must continue following Rev. Proc. 9848, as to the timing, manner, scope and revocation of the election.

Conclusion

American small businesses will continue to provide the lifeblood of the U.S. economy and its economic engine. The tax incentives of Sees. 1045, 1202 and 1244 should be considered in tax planning throughout the life cycle of a small business. Unfortunately, the intended benefits of a Sec. 1202(a) election have been largely mitigated by the AMT. However, the capital gain exclusion might be pertinent in the future if a new administration tampers with the capital gain rate. Nevertheless, Sees. 1045 and 1244 are still powerful tax incentives in the right circumstances.

FROM JOHN W. MORRISSET, CPA, DAMITZ, BROOKS, NIGHTINGALE, TURNER & MORRISSET, SANTA BARBARA, CA