TRA '97 and IRS restructuring bill shifts emphasis to small business investment.

• Author: Orban, Russ

A number of small changes made by the Taxpayer Relief Act of 1997 (TRA '97), when combined, should increase demand for investment in small companies. With a little help from a new provision in the Code and the advent of Internet investment shopping, high-growth small businesses should get a much bigger slice of the pie of investment capital. Growing small businesses will have access to investors around the country, and qualified investors will be able to get ground-floor information about the best investment opportunities. Small business and capital gains. Congress enacted new Sec. 1045, which established a special "rollover" procedure to help steer investments to "qualifying small businesses" Using the provision correctly, an investor (or groups of investors banded together to create a fund) can cut their tax bill by 30% to 60%, or defer taxes on gains from these sales for many years, creating a diversified portfolio of growth funds.

How it works. Under Sec. 1202, gains on investments in qualifying small businesses are already taxed at a bargain rate of 14%, if the stock is held for five years and meets other criteria to make it a qualified stock in an active business. Unfortunately, the long holding period and other requirements served to discourage potential investors who were concerned about a lack of flexibility. For example, what happens if the business is bought out? What if the project is immediately profitable or terminally lackluster? The new law lets an investor cash out of one qualifying investment after only six months; the proceeds can be rolled tax-free into another qualifying small business within 60 days. The profit or gain is not taxed until the replacement stock is sold; the gain is then taxed at 14%. The five-year holding period still applies, but the holding period is cumulative. Consequently, the investor's date of purchase is considered the date the original, first-qualifying stock was bought. Additionally, replacement stocks can be rolled over into new replacement stocks. An aggressive investor can build a strong portfolio with pre-tax earnings, by picking good stocks and continually reinvesting the gains in small businesses. Section 6005(f) of the IRS Restructuring Bill makes it clear that groups of investors, such as venture capital funds, partnerships or...