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New Opportunity to Lock In Zero Percent Capital Gains Rate

October 18, 2010

On January 1, 2011, the long term capital gains rate is widely expected to rise from 15 percent to 20 percent under the tax plan long supported by President Obama. Moreover, beginning in 2013, the tax rate on capital gains recognized by individuals with adjusted gross income in excess of $200,000 ($250,000 for joint filers) is scheduled to rise another 3.8 percent as part of a new provision enacted to pay for the new health care law. While it is possible that these increases may be reversed, the federal tax on gains in corporate shares or other assets purchased today could be as high as 23.8 percent in 2013, a 56 percent increase over today's rates.

As explained in a recent article in the Wall Street Journal [Emily Maltby, "For New Tax Breaks, Act Fast," Wall Street Journal, Sept. 30, 2010 ], however, the President recently signed into law a new provision that creates an immediate opportunity to lock in a zero percent capital gains rate on long term investments in small business stock. Unlike similar tax benefits, there is no income phase out, and the benefit is not subject to the Alternative Minimum Tax (AMT). Taxpayers have from September 27 until the end of 2010 to purchase stock to take advantage of the new provision. However, those who acquire stock within this window could profit handsomely.

The new provision modifies the existing law tax break for small business stock purchases in two ways. It provides for a zero percent rate on 100 percent of the gain, not just the first 50 percent, on sales of qualifying small business stock, and it removes the gain from the AMT calculation. These modifications will increase the usefulness of this tax break for most investors. Insiders also can take advantage of these benefits by acquiring stock in their own firms, but the time window to take advantage of the new law for all investors is narrow: until the end of 2010. In the current budget and political environment, the prospects for a further extension of this window are uncertain. Therefore, investors or insiders who are able to close on a qualifying small business stock investment should consider doing so in the near future.

Qualifying small business investments are investments by individuals or partnerships in the stock of a regular corporation (not an S corporation) with less than $50 million in assets. The stock must be purchased as part of an offering by the corporation, directly or through a broker, and it must be held for at least 5 years. Options to acquire stock, warrants, or convertible notes generally do not qualify as small business stock, but stock acquired through the exercise of an option, warrant, or conversion feature may be eligible in some cases. This would depend on the form of the instrument and requires careful analysis. The amount of gain that can be excluded is limited to the greater of ten times the investment or $10 million. Because the limitation is the greater of the two amounts, the amount excluded can exceed $10 million in some cases. The small business corporation's assets must be $50 million or less from its formation to the period immediately after the stock offering, taking into account the value of the offering itself.

Another important consideration is that the corporation must be engaged in an active trade or business. This means that at least 80% of the corporation's assets are used to carry on a business, or to conduct research or startup activities. Moreover, a variety of businesses are ineligible, including:

  • Service businesses that rely on the skill or reputation of one or more individual;
  • Banking, insurance, financing, leasing, investing, or similar businesses;
  • Farms;
  • Mining and extraction industries; and
  • Hotels, motels, restaurants, or similar businesses. 

Small businesses that are expected to be acquired by larger and more stable companies may be particularly good investments for purposes of this tax break, because the tax rules allow investors to hold on to the stock of the larger acquiring company to meet the five-year holding requirement. In other words, investors are not forced to sell and recognize their gains prematurely and at a higher tax rate when a small business is acquired in a tax free reorganization by a larger firm, a common exit strategy for startup investors.

Another advantage of this newly enacted provision compared to existing law is that the gain is completely excluded for purposes of the AMT. Under prior law, even though 50 percent of small business stock gain could be excluded, part of the gain was added back in the AMT calculation, resulting in a very substantial loss of benefits for AMT taxpayers. For small business stock acquired after the December 31, 2010 deadline, 28 percent of the gain excluded is subject to AMT. Again, this underscores the importance of acting before the deadline.

For more information about the Small Business Jobs Act and advice about how to take advantage of the zero percent rate in particular circumstances, please contact Wayne D. Roberts at 616-776-7514, Steven E. Grob at 313-568-6582, or Steven W. Swibel at 312-627-5676.


As part of our service to you, we regularly compile short reports on new and interesting developments in taxation and the issues the developments raise. Please recognize that these reports do not constitute legal advice and that we do not attempt to cover all such developments. Readers should seek specific legal advice before acting with regard to the subjects mentioned here. Rules of certain state supreme courts may consider this advertising and require us to advise you of such designation. Your comments on this newsletter, or any Dykema publication, are always welcome. © 2010 Dykema Gossett PLLC.

As part of our service to you, we regularly compile short reports on new and interesting developments and the issues the developments raise. Please recognize that these reports do not constitute legal advice and that we do not attempt to cover all such developments. Rules of certain state supreme courts may consider this advertising and require us to advise you of such designation. Your comments are always welcome. © 2017 Dykema Gossett PLLC.