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If you are working with a small start-up company, you may have a unique opportunity to help your company raise money and lower taxes at the same time. Interested? You should be. Smart investors consistently strive to maximize returns and minimize taxes. Occasionally, the Internal Revenue Code provides special tax incentives to help accomplish specific public policy goals. One incentive that has not received a lot of publicity involves investing in Qualified Small Business stock. Investors in QSB stock can defer gains through rollovers and potentially exclude 50 percent of realized gains. Your company probably relies on you to structure its business to make it attractive to investors and, of course, to make the owners personally wealthy. You can accomplish both goals by helping the company become a qualified small business and by alerting potential investors to the special tax benefits. Alternatively, the owners of your company may already have big QSB gains that you can help them to defer or exclude. A QSB candidate will likely be a relatively new, relatively small company, issuing stock to employees, private investors, and venture capital funds or as part of an initial public offering. Investors can’t get QSB stock by simply calling their broker, unless they are buying in an initial public offering or subsequent stock offering, and even then, the company may not be a QSB. In order to qualify for the special tax benefits, all of the following requirements must be met: The company: � must be a domestic C corporation; � must have less than $50 million in assets at the time of stock issuance. For parent-subsidiary relationships involving greater than 50 percent ownership, combined assets must be used; � must use at least 80 percent of its assets in the active conduct of a trade or business. This does not include hotels, motels, restaurants, or professional services such as engineering, medicine, law, and consulting; and � must have issued the stock after Aug. 10, 1993. The investor: � must be a noncorporate entity; and � must have acquired the stock at its original issue, either directly from the corporation or its underwriters. Stock options, warrants, and convertible debt all qualify as QSB stock if they meet all of the other requirements. Under IRC �1045 and 1202, there are two types of tax incentives available for QSB stock: deferral through rollovers and 50 percent exclusion for long-term holds. Investors who have held QSB stock for more than six months can defer gains on stock sold by rolling the proceeds into one or more new QSB stock holdings. Once the initial QSB stock is sold, they have 60 days to reinvest in new QSB stock. In many cases, that means the investor is likely selling before having found a suitable replacement. IPO investors, especially, may find the clock is ticking on them. It is frequently hard to buy the quantity you want in an IPO, and, worse, IPOs have been known to be pulled or postponed at the last minute, leaving the investor without a suitable replacement vehicle. Using venture capital funds is an easy way to invest in QSB stocks, but not an easy way to reinvest after a sale. To do so, the investor must put his funds into the venture capital fund within 60 days and the fund must reinvest in QSB stock within that same period-not an easy feat to accomplish. In any case, to successfully complete the rollover, you have to follow the rules and pay attention to the details. � An election must be made by the later of the due date of the tax return or Dec. 31 of the transaction year to qualify for this treatment. � The replacement stock must meet the “active business” requirement for the first six months following the purchase. � The investor must reduce the tax basis in the new QSB stock by the amount of gain deferred. � If the investor does not reinvest all of the proceeds from the sale, then the balance is subject to tax. For example, Susan Smith buys A Co. QSB stock for $100,000. She holds the stock for seven months and then sells it for $175,000. The realized gain is $75,000. The following week, she buys additional QSB stock from M Inc. for $175,000. She would not have to recognize any gain on the sale of A Co. But if she bought $165,000 of M stock, then she would have to either recognize a $10,000 gain (a short-term capital gain, since she held it only seven months) or invest the remaining $10,000 in another QSB stock within the 60-day period. This is a simplistic example. Now, let’s add some real-life complexities. Susan doesn’t buy A stock; she starts her own company, investing $100,000. Like many start-ups, she expects early losses. Do you advise her to organize as a C corporation to qualify as a QSB to potentially defer her gains? Or do you advise her to organize as an S corporation or limited liability company so she can benefit from early tax losses? If she starts as an S corporation, her initial stock holdings will never be QSB stock: QSB stock must be issued from a C corporation. She could, however, start as an LLC, deduct her early losses, and subsequently convert to a C corporation. Susan’s business does very well. After a few years, she is ready to take the company public. You’ve advised her of all the benefits of being a QSB and, based on your excellent advice, her stock qualifies. She will sell a moderate amount in the IPO and wants to reinvest about half her proceeds in other QSB stock. Here is Susan’s very realistic dilemma: With all the pressure, long hours, road shows, etc., involved in the IPO process, how will she ever find time to research and understand the risks of investing in any particular QSB stock? These investments are generally much riskier than investing in established companies with a long and consistent operating history. Since the timing of her IPO is difficult to predict, she would need several potential QSB investments lined up in order to have something suitable available when she needs it. In most cases, this just isn’t going to happen, and even if it did, it is in Susan’s best interest to devote all her efforts to the public offering, not to a potential reinvestment. Never let the tax tail wag the economic dog. 50 PERCENT EXCLUSION To qualify for the 50 percent gain exclusion, investors have to be more patient: The QSB stock must be held more than five years. If the stock was acquired through reinvestment of a prior QSB sale, then the holding period includes the holding period of the original stock. There is a limit on gains eligible for the 50 percent exclusion. The gain cannot exceed the greater of $10 million or 10 times the investor’s basis in the QSB stock. This limitation is per company, not per purchase. So while you can buy several QSB stocks and each will qualify for the up to $10 million of gain, you can’t buy one QSB stock at different times and have each purchase qualify. Here is an example showing the use of both types of tax incentives: Joe Jones purchases stock in ABC, a QSB corporation, for $50,000 on Oct. 24, 1997. On July 15, 1998, he sells the stock in ABC for $100,000. One month later, Joe uses the proceeds to invest venture money in your company, purchasing $100,000 of your QSB stock. By doing this, he defers tax on his $50,000 gain and reduces his basis in your company to $50,000. That’s the first type of benefit. Five years and a day after Joe’s original purchase of ABC, your company is bought out by BigPublicCorp., and Joe receives $500,000 for his shares. Joe is eligible for the 50 percent exclusion. (So are all the investors who owned qualifying stock in your company.) His gain is $450,000, of which Joe excludes $225,000 (50 percent). The maximum capital gain tax rate applicable for QSB transactions is 28 percent, so Joe’s tax liability would be $63,000. The result is that Joe pays only 14 percent federal tax on his gain. (Same for your investors, and they love you!) At this point, you need to remind your company about the alternative minimum tax. Currently, 42 percent of the gain excluded must be added back as an AMT preference item. This could potentially increase the tax rate on gains to nearly 20 percent, the same rate you would likely pay on non-QSB stock. But for QSB stock purchased after Dec. 31, 2000, the AMT preference portion will be 28 percent of the excluded gains rather than the current 42 percent, giving an effective AMT rate of nearly 18 percent. Virginia and the District of Columbia both follow federal rules, allowing deferral, exclusion, or both, as reported on your federal return. Maryland requires the addback of approximately 50 percent of the excluded gain, meaning Maryland will tax, at ordinary rates, nearly 75 percent of the total gain. So who is a likely candidate to benefit from investing in QSB stock? Someone with significant ordinary income relative to the amount of the total QSB gain. If, on the other hand, the QSB gain dominates the investor’s tax position, the AMT is likely to erase most benefits, other than the state tax savings. Congress has given investors some attractive tax benefits as long as they jump through the proper hoops. For those who are game, it can be rewarding to invest in small start-up businesses and relatively easy to diversify holdings without triggering tax. By structuring your company as a QSB company, your owners and investors may be able to pay less tax on gains and keep more cash in their pockets. Valerie C. Robbins is a certified public accountant and a partner with the accounting firm of Beers & Cutler PLLCin their Tysons Corner office.

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