Qualified Small Business Stock:

An Improved Investment Tool
Summary: Recent tax law changes have made investment in growth stocks far more attractive that investing for income. In fact, qualified small business stock has the lowest tax rate on a long-term capital gain, 14% and permits the investor to rollover into another qualifying stock deferring tax until the future sale. For investors who have significant gains in the market and are looking to diversify into stocks with long-term growth potential, special small business stocks may be the correct solution. ACE-Net can be an attractive "meeting place" for companies and individuals interested in this type of stock. However, small company stock is not for everyone: there are restrictions on the type of activity and investments a company issuing the stock may engage in, and the alternative minimum tax ("AMT") may apply to some investors.

Introduction
Small businesses looking for equity capital may want to consider issuing special stock that is subject to an extra-low capital gains tax rate of as little as 14 percent. Recent tax law changes make this quite attractive for both investors and companies looking for capital. Special small business stock does have qualification requirements that should be considered.

Qualified Small Business Stock
Under Internal Revenue Code section 1202, "qualified small business stock" is any stock in a C corporation if the corporation is a "qualified small business" on the date of issuance of the stock, and the taxpayer acquires the stock at original issue (directly or through an underwriter), rather than once the stock is already trading. To be a qualified small business, the corporation (including 50 percent owned subsidiaries) must have aggregate gross assets of $50 million or less after issuing the stock and at all times before. The corporation must meet an "active business" requirement or be a specialized small business investment company. The active business requirement includes several restrictions on the type of business the company engages in and what it does with its assets.

The Exclusion
Taxpayers may exclude half the gain on the greater of $10 million or 10 times the qualified stock issued by a corporation, if they hold the stock for more than five years. The 50 percent exclusion reduces the maximum regular tax rate on qualified stock to 14 percent, vs. the 20 percent rate investors would pay on long-term gains on regular stocks..

In addition, thanks to a changes made by the Taxpayer Relief Act of 1997and the Internal Revenue Service Restructuring and Reform Act of 1998, taxpayers can "roll out" of their holdings of one qualified small business stock after only six months, provided they "roll into" another qualified small business stock within 60 days. Their holding period for the five-year test is considered to date from the first purchase. This change gives investors much more flexibility than under the original section 1202. Not only can they switch investments among qualified stock more frequently, they can defer gain completely until they sell qualified stock and do not replace it. Restrictions apply to shareholders with offsetting short positions, however.

Alternative Minimum Tax (AMT)
For AMT purposes, a portion of the small business stock incentive is reclaimed. Taxpayers must include 42 percent of the excluded gain as a preference item for purposes of AMT. Thus, a taxpayer who must pay tax subject to the AMT will have an effective rate on his qualified gains of 19.88 percent rather than 14 percent.

Qualified Stock and ACE-Net
ACE-Net provides a way for businesses to offer section 1202 stock to qualified investors. Because there are numerous restrictions on both issuers and holders of section 1202 stock, it is somewhat complicated and may be difficult to sell to investors through more typical channels. But ACE-Net is designed for accredited investors and equity seekers who can more readily deal with the rules surrounding qualifying small business stock.

Source: Russ Orban, Assistant Chief Counsel for Tax Issues, Office of Advocacy, U.S. Small Business Administration, Washington, DC (November 6, 1998).