The reading level for this article is Novice

For once the government and entrepreneurs have one thing in common: they both think that investing in small growing businesses is a good idea. In order to encourage investment in small businesses, Congress has authorized tax benefits for people who invest in certain small businesses.

If a small business meets the definition of a Qualified Small Business ("QSB"), as defined in the applicable sections of the Internal Revenue Code (the "Code"), investors in the business will have the opportunity to benefit from up to three types of preferential tax treatment:

• a 50% exclusion of gain realized by the investor upon the disposition of the stock (Section 1202 of the Code);
• deferral of the gain realized by the investor if the investor "rolls over" such gains by purchasing additional QSB stock (Section 1045 of the Code); and
• if the investor losses money on the investment, re-characterization of any capital losses as ordinary losses (Section 1244 of the Code).

These tax benefits are important to entrepreneurs in order to attract investors to their companies and to investors to minimize risks in the investment and increase their rates of return. Tax laws and Internal Revenue Service regulations are long, complex and almost nonsensical, and thus this article is only an overview of these tax provisions. Entrepreneurs and investors should consult with their own tax advisors to determine whether they can benefit from these tax provisions.

The first hoop to jump through in order to get this preferential treatment is to qualify as a QSB. There is one set of criteria to qualify as a QSB for the 50% exclusion and roll-over tax deferral (Sections 1202 and 1045), and another set of criteria to qualify as a QSB for the ordinary losses (Section 1244).

In order for stock in a company to be QSB Stock for the 50% exclusion of gain and roll-over tax deferral, all of the following requirements must be met:

• the stock must have been issued after August 11, 1993;
• the stockholder must have received the stock as an original issue;
• the aggregate gross assets of the Corporation must not have exceeded $50,000,000 at the time of and immediately after the issuance of the stock;
• at least 80% of the assets, by value, of the Corporation must have been used in active trade or business. Active trade or business does not include farming and certain service-related trade businesses (such as financial services, performing arts, architecture, operating hotels – see Section 1202 (e) of the Code for more detail); and
• the Corporation must be a domestic "C" corporation.

Section 1045 allows investors who are not corporations to sell stock in a QSB corporation without recognizing any taxable gain if the investor rolls the gain into new QSB corporation stock within a sixty day period from the date of the sale. In order to benefit from Section 1045 rollover treatment, the investor must have held the QSB stock more than six months. If the gain realized by the investor on the sale of the QSB stock exceeds the cost of any QSB stock purchased by the investor during the sixty day period beginning on the date of such sale, then the investor will be taxed upon the amount of gain that exceeds the cost of the stock that is subsequently purchased.

An investor seeking to benefit from Section 1045 must elect to receive Section 1045 treatment. Currently, the election may be made by first reporting the gain from the sale of the QSB stock on Schedule D filed with his or her federal income tax return. Then, the investor should write "Section 1045 rollover" below the line on which the gain is reported and enter the amount of the gain deferred under Section 1045 on the same line as the above statement as a loss in accordance with the instructions for Schedule D. The investor should note, however, that tax forms change from year to year and if in doubt as to how to elect Section 1045 coverage the investor should check with his or her own tax advisor or consult current Internal Revenue Service manuals.

Section 1202 allows investors who are not corporations to exclude 50% of their taxable gain recognized from the sale or exchange of QSB stock held for five or more years. If the investor has common stock that was converted from preferred stock, the holding period starts when the original preferred stock was first acquired. An individual who receives the stock by inheritance or as a gift is deemed to have held the stock since the original taxpayer’s acquisition date.

Several rules limit an investor’s ability to take advantage of the 50% exclusion rule. An investor may only use the 50% exclusion rule for up to $10 million or ten times the investor’s basis in the small business corporation stock, whichever amount is greater.

Additionally, investors subject to the alternative minimum tax may have some of the excluded income under Section 1202 added back to their taxable income for purposes of computing alternative minimum tax. The possibility of alternative minimum tax inclusion drastically reduces the benefits of Section 1202, resulting in Section 1045 being the primary benefit investors receive from QSB stock.

There is always a downside risk to investing in a small high-growth business. If the company does not do well, and the investor loses the investment, the investor may be able to use those losses as ordinary losses instead of capital losses to offset ordinary income. Section 1244 provides for the treatment of losses from investments in certain Qualified Small Business corporations as ordinary losses. In order for a corporation to be a QSB for Section 1244 purposes:

• the corporation must not have received more than $1 million in equity capital at the time of the investment; and
• more than 50% of its aggregate gross receipts must come from sources other than royalties, rents, dividends, interests and annuities, and sales or exchanges of stocks or securities.

In order to take advantage of Section 1244, an investor must have received stock from the QSB as an original issue and in exchange for money or property (but not stock or other securities). Loss to be treated as ordinary loss may not exceed $50,000 per taxable year or $100,000 in the case of a joint return per year. Section 1244 re-characterization of losses is available only for individuals either directly or through partnerships; Section 1244 re-characterization is not available for investors who are either limited liability companies or corporations.

All of the tax advantages we have discussed here are subject to several exceptions and exclusions, and entrepreneurs and investors are encouraged to work with their tax professionals to maximize their potential tax savings. All of these benefits, if properly utilized, will greatly benefit an early stage company and its investors, thus minimizing some of the risk inherent in investing in a small company.

This article was published in the May 2002 issue of the Triangle TechJournal.

This Entrepreneurship article was written by Hutchison and Mason PLLC on 2/11/2005

Hutchison & Mason, PLLC is a Raleigh, North Carolina based law firm specializing in information technology and life science companies. Their web site is