Encouraging Investment in Small Business Act
Senators Collins, Cleland, and Breaux
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 nations 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
QSBs 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 QSBs 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 taxpayers 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. Janes
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
(d)(2) Exception from Redemption Rules Where Business
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
(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
(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