Encouraging Investment in Small Business Act

Senators Collins, Cleland, and Breaux

Section-by-Section Summary

  1. Introduction

The Encouraging Investment in Small Business Act is intended to stimulate private investment in the entrepreneurs who drive our economy. The Act will encourage long-term investment in small and emerging businesses by rewarding investors who risk investment in such firms. According to the Small Business Administration, small firms account for three-quarters of our nation’s employment growth and almost all of our net new jobs. Small businesses employ 52 percent of all private workers, provide 51 percent of our private sector output, and are responsible for a disproportionate share of innovations. Moreover, small businesses are avenues of opportunity for women and minorities, young and elderly workers, and those formerly on public assistance. Yet entrepreneurs need access to more capital to start and expand their businesses.

In 1993, Section 1202 was added to the Internal Revenue Code in order to encourage investment in small businesses. In brief, Section 1202 permits non-corporate taxpayers to exclude from gross income 50% of the gain from the sale or exchange of qualified small business ("QSB") stock held for more than five years. The concept is a sound one. However, in practice, Section 1202 has proven to be cumbersome to use and less advantageous than originally intended. As an article in the December 1998 edition of the Tax Adviser noted, "Sec. 1202 places numerous and complex requirements on both the QSB and the shareholder," and that the provision "is no longer the deal it seemed to be."

The Encouraging Investment in Small Business Act would amend Section 1202 to eliminate unnecessary complexity and to make it a more robust engine of capital formation for small businesses. As it now stands, the engine needs work. Given 1) reductions in capital gains rates subsequent to Section 1202's enactment and 2) the fact that more taxpayers are now subject to the Alternative Minimum tax, Section 1202 is no longer a viable option in many circumstances it was originally intended to address. Moreover, Section 1202's impact will continue to be diluted by a scheduled decrease in long-term capital gains rates applicable to stock purchased after 2000 and the probability that still more taxpayers will be subject to the AMT. To understand the changes the Act would make, it is first necessary to understand how 1202 currently works.

As noted, Section 1202 imposes numerous restrictions on a business that seeks to qualify under its provisions. To be a QSB, a business must be a domestic C corporation with aggregate gross assets of no greater than $50 million at any time prior to or immediately after issuing stock. Certain types of businesses are excluded from QSB status, including banking, insurance, investing, consulting, law, accounting, financial services, and farming concerns as well as hotels and restaurants. Any trade or business that relies on the reputation or skill of one or more of its employees as its principal asset also cannot be a QSB.

QSB’s must also satisfy an "active business" requirement. This means that, during substantially all of the time the taxpayer holds the stock, at least 80 percent of the QSB’s gross assets must be used by the corporation in the active conduct of the qualified trade or business. Assets used in certain start-up activities or for research, or which are held as "reasonably required" working capital are deemed to be used in the active conduct of a qualified trade or business. Two years after a QSB has come into existence, no more than 50 percent of its assets can qualify as "active" by virtue of the Section 1202(e)(6) working capital rule.

As noted, under Section 1202, an individual can exclude from gross income 50% of any gain from the sale or exchange of qualified small business stock originally issued after August 10, 1993 and held for more than five years. Under Section 1045 of the Code, the taxpayer may roll the gain over tax-free provided that the taxpayer 1) has held the QSB stock for more than six months and 2) invests the gain in other QSB stock within 60 days of the sale. Generally, the holding period of the stock purchased will include the holding period of the stock sold.

The maximum amount of a taxpayer’s gain eligible for the Section 1202 exclusion is limited to the greater of $10 million and 10 times the aggregate adjusted bases of the stock sold. Gains on Section 1202 stock are taxed at the rate of 28%.

II. Section-by-Section Analysis

Section 1. Short Title.

The "Encouraging Investment in Small Business Act."

Section 2. Increased Exclusion and Other Modifications Applicable to Qualified Small Business Stock.

(a) Increased Exclusion.

This provision increases the amount of QSB stock gain that an individual can exclude from gross income from 50 percent to 75 percent.

(b) Reduction in Holding Period.

This provision reduces from 5 years to 3 years the period of time in which an individual must hold QSB stock in order to qualify for the 75-percent exclusion. Section 1045's rollover provisions will still apply.

(c) Repeal of Minimum Tax Preference.

This provision strikes Section 57(a)(7), which makes 42 percent of the amount excluded pursuant to Section 1202 a preference item under the alternative minimum tax. This change is necessary because the AMT provisions in existing law effectively eviscerate the benefit of Section 1202 in certain situations.

Example. Jane buys Section 1202 stock for $2,000. After five years, she sells the stock for $12,000. Under current law, she excludes half of her gain and is taxed at 28% on the other half [.28 x $5,000 = $1,400]. Hence, her tax on the gain is $1,400. However, if Jane is subject to the AMT, she must pay additional taxes of $588, or 28% of 42% of the excluded half of the gain. Jane’s total tax bill of $1,988 amounts to an effective rate of 19.9%, or nearly the same as the current maximum tax rate on long-term capital gains of 20%. Under the Encouraging Investment in Small Business Act, Jane would be able to exclude 75% of her gain, would be subject to the 20% rate that applies to most capital gains, and would not have to recognize any of the gain as a preference item for AMT purposes. Hence, her tax bill would be 20% of $2,500, or $500. Absent the change, Jane would have little incentive to invest in a qualified small business over any other business, particularly if she is subject to the AMT. Under the Encouraging Investment in Small Business Act, Section 1202's original potent incentives to investors in small businesses are restored.

(d)(1) Working Capital Limitations.

This provision eases Section 1202(e)’s working capital restrictions on qualified small businesses. The provision increases from 2 years to 5 years the time in which assets that are held for investment by a business can be expected to be used to finance research or an increase in working capital needs. In other words, a corporation will be able to hold assets longer, before eventually using them for research or to satisfy increased working capital needs, and still meet the active business requirements of Section 1202.

(d)(2) Exception from Redemption Rules Where Business Purpose.

Currently, the Section 1202 exclusion does not apply to stock issued by a corporation if the corporation purchases more than 5 percent of its own stock during the 2-year period beginning on the date one year before the issuance of its stock. Under the Encouraging Investment in Small Business Act, this provision would be waived if the issuing corporation could establish that the purchase was made for a business purpose, and not to avoid the provision described above.

(e) Excluded Qualified Trade or Business.

This provision tightens the language of Section 1202(e)(3), which excludes certain businesses from QSB status. It does so in two ways. First, it provides that a corporation can be a QSB even if its principal asset, for a temporary period, is the reputation or skill of one or more of its employees. Hence, in the case of a small start-up computer software company, for example, if its employees engage in consulting work, say, in order to generate some cash flow while the software is under development, the company will not be disqualified from QSB status.

Second, the provision makes it clear that biotechnology and aquaculture companies are not disqualified from QSB status.

(f) Increase in Cap on Eligible Gain for Joint Returns.

The Encouraging Investment in Small Business Act fixes a marriage tax penalty provision in Section 1202 by doubling (to $20,000,000) the maximum amount of eligible gain for taxpayers filing joint returns.

(g) Decrease in Capital Gains Rate

Section 1202 gains are currently taxed at a rate of 28 percent, which, prior to May 7, 1997, had been the maximum marginal rate for net capital gains. The Taxpayer Relief Act of 1997 reduced the maximum capital gain rate for individuals from 28 percent to 20 percent, but left section 1202 gain subject to the 28 percent rate. The Encouraging Investment in Small Business Act would make section 1202 gains subject to the generally-applicable 20 percent rate.

(h) Increase in Rollover Period for QSB Stock

Currently, a taxpayer can roll over, tax free, gain from the sale or exchange of QSB stock where the taxpayer uses the proceeds to purchase other QSB stock within 60 days of the sale of the original stock. The Encouraging Investment in Small Business Act would increase the roll over period to 180 days, thus increasing the liquidity of QSB stock. A 180-day roll over period is also employed in section 1031 of the Internal Revenue Code for like-kind exchanges.

Source: www.govtrack.us


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