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Small business tax exemption may apply, but only until Dec. 31

[caption id="attachment_27483" align="alignleft" width="108" caption="Ronald Wargo"][/caption]

Most of you have heard those late-night infomercials promising a once-in-a-lifetime opportunity to buy a spectacular product if you just act now.  Our federal government has just such an opportunity for you, but hurry, because time is limited.

In September 2010, President Obama signed the Small Business Jobs Protection Act (the “SBJP Act”) modifying tax treatment of capital gains on investments in small businesses.  With the right combination of events, investors and founders of small businesses can now exclude 100 percent of the capital gain from the sale of their stock in the business.

For a limited time only

For many years, investors in Qualified Small Business Stock (“QSBS”) have been able to exclude 50 percent of the gain on the sale of such stock.  In 2009, this 50 percent exclusion was increased to 75 percent.  With the AMT and an increased (28 percent) capital gain tax on the remainder, this benefit was not great for most investors.  Now, if you purchase the right stock between Sept. 28, 2010, and Dec. 31, 2010, (that’s right, only through the end of the year) you too can exclude 100 percent of your capital gain.

Of course, as with any late-night TV product, the lawyers must quickly read the fine print.

One-of-a-kind product

The 100 percent gain exclusion for QSBS only applies to stock in C-corporations, which themselves are subject to double tax and other issues that may not be relevant to your existing small business.  Interests in LLCs, S-corporations and partnerships will not qualify.

Offer good while supplies last

When acquired, the corporation issuing QSBS must have no more than $50 million in assets.  In addition, at least 80 percent of the corporation’s assets must be actively used in the corporation’s trade or business.  Holding companies need not apply.  Other active businesses, such as banks, service businesses or farms, cannot qualify.

May cause headaches, insomnia

The corporation issuing the QSBS must agree to submit reports to the IRS as the IRS determines from time to time.  You can be sure that if your business is successful, that will become a nightmare, but this reporting requirement applies even to small companies.

Must be 18 years of age to order

Only individuals may qualify for this tax treatment, not other corporations.  Pass-through entities which own C-corporations should be able to pass-through the QSBS benefit to their individual owners.  Furthermore, investors must hold their QSBS for at least five years after purchasing it.

Not a flying toy

Individuals do not actually get to exclude 100 percent of the gain in an infinite amount.  If you have invested in the next Google, you are limited to excluding 100 percent of the gain up to the greater of $10 million or 10 times the aggregate adjusted basis of the QSBS disposed of during the taxable year.

And if you act now

OK, no steak knives, but you can sell some QSBS a mere 6 months after purchase, and you will have no gain, provided that you purchase new QSBS within 60 days of the sale.  The five-year holding period runs from the date of the original QSBS purchase.

Time is running out

The IRS doesn’t do infomercials very well, but this little-known tax break can benefit some investors and founders for a very short period of time.  Primarily, if you are investing in a small C-corporation, you might want make sure your investment is completed before the end of 2010.

Please consult with your tax adviser if you wish to convert an existing S-corporation, LLC or a partnership to a C-corporation to take advantage of this short-term tax break.  Converting an entity into a C-corporation can often have additional tax consequences, and C-corporation operations can be significantly different from pass-through entities such as LLCs, partnerships and S-corporations.

And the real legal fine print

Pursuant to the requirements of Internal Revenue Service Circular 230, we advise you that any federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

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Ronald Wargo, a partner with the law firm of Friedemann Goldberg LLP, practices in the areas of estate planning, business law and intellectual property. For questions about this article, please contact him at 707-543-4900 or rwargo@frigolaw.com.