Obama Administration, Treasury Propose No Capital Gains Tax on Qualified Small Business Stock
In the aftermath of the capital market, credit market and banking crises that have gripped the U.S. economy, President Obama and his administration have called for broad reforms of the American financial system. To that end, the United States Department of the Treasury released the General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals (the “Tax Proposals”) on May 11, 2009. The Tax Proposals contain, among other things, the following provisions that, if enacted, could have a considerable impact on the tax treatment of qualified small business stock issued after February 17, 2009 and therefore could have a considerable impact on the investment decisions of venture capital and private equity funds.
Under current law, in order for stock to qualify as “qualified small business stock”, at the time the stock is issued, the issuer may not have gross assets exceeding $50 million (including the proceeds of the newly issued stock) and may not be a subchapter S corporation. The issuer must also meet certain active trade or business requirements and there are limits on the amount of real property that the issuer may hold. The current rules exclude 50% of the recognized gain on the disposition of a qualifying corporation’s stock acquired at original issue and held by taxpayers (other than corporations) for five years prior to divestiture for the purposes of the calculation of capital gains under the regular income tax system. This percentage was increased to 75% for qualified small business stock issued after February 17, 2009 and before January 1, 2011 by the American Recovery and Reinvestment Act.
The ultimate tax benefit with respect to the current exclusion is significantly diminished due to a number of applicable limitations. The portion of the gain that is not subject to the exclusion (and thus includable in taxable income) is taxed at a maximum rate of 28%. Thus, for a taxpayer in the maximum marginal tax brackets, the effective tax rate on gain recognized on the sale of qualified stock is 14% (7 % if the stock was issued after February 17, 2009 and before January 1, 2011). However, because a percentage of the excluded gain is a tax preference item under the alternative minimum tax rules and is included in the computation of alternative minimum taxable income, in many cases the AMT will significantly reduce the tax savings which are supposed to be afforded to gain recognized on the sale of qualified small business stock.
Additionally, the amount of gain eligible for the exclusion is limited to the greater of $10 million or 10 times the taxpayer’s basis in the stock. Accordingly, the most valuable tax benefit available under the qualified small business stock rules may be the ability to “roll over” capital gain realized from the sale of qualified small business stock into the stock of another qualified small business, provided certain conditions are satisfied. This too may not be of great benefit since the long term capital gain rate will likely be higher than the current 15% in the future when the rolled over gain is recognized on a sale of the stock into which the gain was rolled over.
The Tax Proposals eliminate many of these limitations by providing a complete exemption from capital gains tax for qualified small business stock issued after February 17, 2009 and sold after being held for a five-year period. No portion of the excluded gain would be subject to the alternative minimum tax. If enacted, the Tax Proposals would significantly enhance the tax incentives currently available for venture capital and private equity fund investments in qualified small business stock and therefore all such financings should be analyzed very closely from a qualified small business stock standpoint. Furthermore, post-financing transactions that have the potential to undercut qualified small business stock status, such as stock redemptions, should be carefully considered before being undertaken.
In light of the Obama administration’s announcement that it intends to “re-regulate the way U.S. financial markets work,” Troutman Sanders LLP’s Reregulation of Banking and Financial Services Team will continue to actively monitor any future developments and provide periodic updates with respect to the Tax Proposals that affect private equity and venture capital funds.