Qualifying for tax breaks

guest commentary by David Potts

September 27, President Obama signed into law the 2010 Small Business Jobs Act. Previously I discussed the provisions of the Act which I thought affected mosts small businesses, the Section 179 expensing of assets and bonus depreciation.

Another generous provision of the 2010 Small Business Jobs Act, although limited to a much smaller group of small businesses, is the 100% exclusion of the gain realized on the sale of qualified small business stock acquired in 2010.

The Internal Revenue Code contains a section that allows individual (non-corporate) taxpayers the right to exclude a certain percentage of any gain from the sale or exchange of qualified small business stock held for more than five years. Originally the exclusion was 50% of any gain. After the passage of the Small Business Jobs Act, qualified small business stock acquired between Feb. 18, 2009 and Sept. 27, 2010 qualifies for a 75% exclusion of gain and for qualified small business stock acquired between Sept. 28 and Dec. 31, 2010, the exclusion is increased to 100%, i.e. tax free. Beginning in 2011 the exclusion returns to 50% for any gain.

What is qualified small business stock? Qualified small business stock means any stock in a domestic C Corporation which is originally issued after the date of the enactment of the Revenue Reconciliation Act of 1993 (August 10, 1993) with assets less than $50,000,000 when the stock was acquired. Part of the reason this provision has a limited audience is that the vast majority of small business corporations today elect to be taxed as S corporations. (C corporations, as an entity,  pay their own income tax. S corporations pass their income through to their stockholders who then pay the tax on their individual income tax returns.)

Also the C corporation must be engaged in an active trade or business (as opposed to an asset holding company) and qualify as an “eligible corporation.” An eligible Corporation is involved in any business “except for the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial services, performing arts, consulting, athletics, financial services, broker services, or any other trade or business where the principal asset if such trade or business is the reputation or skill of one or more of its employees; any banking, insurance, financing, leasing, investing, or similar business; any farming business; any business involving the production or extraction of products of a character with respect which a deduction is allowable under section 613 or 613A [basically any mining, timber, or oil and gas activities]; any business of operating a hotel, restaurant, or similar business.” Oh. I almost forgot. You also can’t be a regulated investment company (e.g. mutual fund), real estate investment trust, or REMIC, or a cooperative.

I once heard Warren Buffet comment that each line of the Internal Revenue Code has its own constituency. When you see such a list of exclusions of certain industries in the Internal Revenue Code, it illustrates Mr. Buffet’s comment. Why were these industries excluded? Lack of political clout? Maybe. However, even with all the exclusions, there a plenty of small businesses in industries that can qualify for this exclusion.

The amount of the gain that can be excluded is limited. The limit is based on a per issuer basis and the gain is limited to 10 times what the investment cost you or $10 million, whichever is the least.

The main problem in taking advantage of this 100% temporary exclusion is a lack of time. In order for a new business to organize, capitalize, and issued stock, and do it correctly … three months, isn’t much time; two and a half months from now.

A side thought.

When writing an article discussing any section of the Internal Revenue Code for a general audience, you’re always faced with choosing which parts of the code section to leave out. This commentary is no different. To discuss all the exceptions and nuances in most code sections could make the discussion tedious, boring, and confusing.

The language in the Internal Revenue Code is technical and requires careful reading to avoid mistakes. But even then there’s a constant line of litigants fighting over what the tax laws really mean. That’s why I always include a disclaimer and tell you to discuss your tax situation with a professional.

On Oct. 13, Pres. Obama signed the “Plain Writing Act of 2010”which requires federal agencies to use writing that is clear, concise, well-organized, and follows other best practices appropriate to the subject or field and intended audience. I wonder who gets to define “clear, concise, and well organized”? The actual law and regulations are excluded from this requirement, of course. I wonder if this new law will be as effective as the Paperwork Reduction Act of 1980?

About Potts
David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, business valuation and business advisory services. He is a Fort Smith native and a graduate of the University of Arkansas. You can follow more of his thoughts at ThePottsReport.com. Although every effort is made to provide you accurate and timely tax information, it is general in nature and not specific to your facts and circumstances. Consult a qualified tax professional to discuss your particular case.

Also, feel free to e-mail topic suggestions or questions to [email protected]