From The Triangle Business Journal, 21 August 1998, page 15.

'Qualified small-business stock' benefits

Legal Focus



The Internal Revenue Code now provides special benefits for investors in "qualified small-business stock."

The terminology is misleading because the qualified companies need not be all that small. Before we fill out the definition, however, let's look at the special benefits provided to owners of qualified small business stock.

Benefits overview

One benefit is a 50 percent exclusion from tax of gain earned upon the qualified sale of small business company stock. This reduces the effective tax rate on the capital gain from a stock sale to 10 percent, in most cases.

For example: Jones buys 100 shares of qualified small business stock in 1993 for $5,000. He sells the shares in 1998 for $105,000. Jones can exclude $50,000 of gain and pay tax at the federal capital gains rate of 20 percent on $50,000, paying $10,000 of tax. The $10,000 is just 10 percent of Jones' $100,000 gain.

A far more interesting and easily available alternative, however, is the permission to "roll over" the gain on qualified small-business stock into stock of another such business.

For example: Same as example above, but Jones bought the stock in 1997, sold it in 1998, and within 60 days reinvests all of the sale proceeds in stock of another qualified small business. Jones owes no tax for 1998 on the sale.

To obtain these federal tax benefits, your investment must be in qualified small business stock, which means the corporation must have these characteristics:

The "active business" requirement excludes corporations with significant amounts of investment assets.

Furthermore, certain types of business are specifically excluded:

These requirements normally can be met by the typical start-up business in the Triangle needing investment capital.

Even if it is thought that the intangible assets of the business -- such as patents or copyrights -- are worth more than $50 million, that will not be a problem so long as those assets were developed inside the corporation and not contributed to the corporation, and do not have a high tax basis.

These factors will be typical of Triangle companies that are developing software or biotech property.

Holding periods for benefits

Using the 50 percent exclusion from small-business investments has been relatively difficult because of the requirement that the stock be held for more than five years. Generally, the stock had to be issued after Aug. 10, 1993, the enactment date of the law in order to qualify its sale for the gain exclusion.

Much more useful is the permission to roll over gain from the sale of qualified small-business stock to other qualified small-business stock.

For this benefit to occur, the stock need not be held for five years. Rather, it need only be held by an individual investor for more than six months. The roll-over investment must be made within 60 days.

This provision can be used both by individual investors and by partnerships or other investment vehicles other than C corporations. Thus, partnerships or S Corporations can provide to their owners the benefit of roll-over of investments in qualified small business stock.

North Carolina tax benefits

Icing on the cake is the fact that both of these benefits should work for North Carolina state income tax purposes. The 50 percent gain that is excluded by the Internal Revenue Code is also excluded for North Carolina income tax purposes through its "piggy- backing" on the federal tax law.

Similarly, the rollover should be provided for North Carolina income tax purposes. Therefore, tax of more than 27 percent of the gain is deferred upon the rollover, and tax of more than 13 percent of the gain is avoided through use of the exclusion.

Ideally, this opportunity should result in additional emphasis on investing in smaller operating companies with good growth potential.

Oftentimes these companies are bought out, which could mean that a series of small company stock rollovers ends in a final rollover by merger into the stock of a larger traded company, with tax never being paid.

Cummings is an attorney in the Raleigh office of Alston & Bird. He can be reached at 420-2208 or