Exclusion for Gains on Small Business Stock

Back in October, we wrote a blog post titled Incentive to Invest (Now!) in C-Corporation Startups summarizing an exciting provision of the Small Business Jobs Act of 2010 (“SBJA”) that was passed at the end of September.  Well, the incentive is now to Invest (Soon!) in C-Corporation Startups due to a year-long extension by the recent tax bill signed into law on December 17, 2010 (the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, referred to herein as the “Bill”).

The tax incentive at issue allows gains from the sale of certain small business stock to be excluded from federal taxes.  The exclusion traditionally applied to 50% of qualifying stock purchased by an eligible investor, but has been recently expanded to: (1) 75% of qualifying stock purchased in 2009 through September 26, 2010, by the American Recovery and Reinvestment Act of 2009, (2) 100% of qualifying stock purchased during the remainder of 2010 by the SBJA and (3) 100% of qualifying stock purchased through 2011 by the Bill.  Some of the several qualifications include:

• Investors that are corporations are not eligible for the incentive;
   
• The stock must be that of a C-Corporation and purchased at original issuance from the company or an underwriter;
   
• The company’s aggregate gross assets cannot exceed $50 million prior to or immediately following the issuance; and
   
• The stock must be held for more than five years.

While a provision for completely tax-free gains was exciting on its face, the SBJA only made it available for qualifying purchases made within a very narrow window.  In practice, we expected this to serve more as a windfall to investors who were already planning to make an investment, rather than encouragement for investors sitting on the sideline. 

However, the Bill extended the 100% exemption for purchases made between September 27, 2010 and December 31, 2011, hopefully creating a welcome stimulus in the investment and startup community.  

Extension of Individual Tax Rates

Most of the focus on the Bill related to the extension of current tax rates for individuals, which includes the investor-friendly reduced maximum tax rates of 15% on capital gains and dividends. 

Retroactive Extension of Tax Credits

The Bill also retroactively extended a couple of important tax credit programs that had expired at the end of 2009.  The Research Credit, or R&D Credit, offers a business tax credit equal to a percentage of qualifying research expenditures and has been extended by the Bill through 2011.  In addition, the New Markets Tax Credits program offers business tax incentives in designated geographic areas and has been allocated an additional $3.5 billion for each of 2010 and 2011, whereas the previous allocations ended with $5 billion in 2009.