Tax planning for small business stock.

• Author: Morrisset, John W.

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...