How Tax Laws Limit Risk to Investors in Small Companies

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Investors in qualifying businesses are entitled to special tax benefits. The tax incentives present an advantage for individual investors to provide companies with new long-term capital investment.

The business must be incorporated and have tax status as a “C corporation“. When an original owner sells the corporation’s stock after a five-year holding period, the investor may exclude 50 percent of the gain from taxable income. With a capital gain tax rate on small business stock of 28 percent, excluding one-half of the gain is an effective rate of only14 percent on the entire gain. The gain from the stock that is eligible for the exclusion is limited to the greater of ten times the basis in the sold stock or $10 million.

To qualify, the stockholder must be an individual—not a corporation. The investor must have been issued the stock by the corporation in exchange for cash or other property (but not other stock) or for services provided to the corporation. The corporation must have $50 million or less in aggregate capital on the date that the stock investment was made. In addition, at least 80 percent of the value of corporate assets must be used in the active conduct of businesses—not passive investment activities. The corporation cannot be a provider of professional services—such as medical care or law—or be involved in finance, banking, leasing, real estate, farming, mineral extraction, or hospitality industries.

The tax benefit transfers to anyone who receives the qualified stock as a gift or transfer due to death of the original purchaser. The transferor’s holding period also carries over to the transferee.

In addition to excluding from taxation part of the gain from selling small business stock, an investor can defer income tax on the entire gain. Investors may roll over a capital gain from the sale of qualified small business stock held longer than six months into the purchase of another qualified small business stock within 60 days. The basis in the replacement stock is reduced by the gain not recognized.

What about a loss on small business stock? Only $3,000 per year of capital loss is deductible against ordinary income. However, under certain conditions, more deduction is available for loss on capital investment in a small business corporation. Losses on small business stock require the complete liquidation of a corporation. 

The stock must have been issued under Section 1244 of the income tax code. A qualifying small business must have aggregate capital of less than $1,000,000 at the time the Section 1244 stock is issued to shareholders. In addition, the corporation must derive more than 50 percent of its gross receipts from sources other than passive investment income.

Record keeping requirements are imposed on the corporation for receipt of funds on Section 1244 stock. The corporation must also designate which of its outstanding shares qualify for Section 1244. Consideration paid by the shareholder must consist of money or other property, not services or securities.

The Section 1244 loss is taken in the year of corporate liquidation. The amount is limited to a loss of $50,000 per individual—or $100,000 on a joint tax return. Any amount exceeding that limit is reported as a regular capital loss.