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Tax Break Helps Small Business, Startups Raise Money

Attention startups and existing small businesses looking to raise money by selling stock. This is huge! You may soon find it easier to attract investors thanks to a largely-overlooked provision in the economic stimulus law that lowers capital gain taxes for individuals who invest in "qualified small business" (QSB) stock.

But suddenly it looks like that tax break could grow from merely good to downright golden under an Obama proposal just issued. Obama aims to completely eliminate capital gains taxes on qualified small business stock held at least five years. Yes, that's right. Zero. It's a game-changing shift. Startups are already salivating at the prospect of putting together stock deals where individuals (but not corporations) who invest - owners, employees, angels, etc. - can exit and pay no capital gain taxes. Here's what's already changed, what may soon change, and what types of businesses and investors qualify:

What's already changed: Under new stimulus law provisions, individuals who buy stock in a small business from now through 2010 get a bulked-up break on capital gains taxes later on. If the stock is held at least five years, 75 percent of any gain can be excluded - up from the previous 50 percent. The stock must be original issue stock held by a non-corporate investor in a C corporation with gross assets under $50 million. The company must also be actively engaged in a trade or business.

What may soon change: The Obama Administration's budget proposal just issued provides for a complete capital gains tax exemption for qualified small business stock issued since February 17, 2009 and held five years. What's more, the gains would not count toward calculating the alternative minimum tax (AMT).

Who qualifies: This tax break only applies to individuals who invest in a U.S.-based qualified small business C-corporation with less than $50 million in assets. S-corporation stock does NOT qualify, even if the business later switches to a C-corp. The biggest drawback is that many types of professional businesses are out. The basic rule is this: The company does not qualify if its principal asset is the reputation or skill of one or more employees, such as a doctor, lawyer or accountant. That rules out service firms in health care, law, accounting, architecture and consulting, among others. But most Internet, tech, retail and manufacturing businesses would qualify.

What to do:

  • Startups in qualified business types should carefully consider C-corporation status, as opposed to LLC, S-Corp or others.

  • Watch carefully what happens to this provision, which falls under Section 1202 of the tax code. Make sure potential investors are aware of the sweet tax benefits they stand to reap by investing in your qualified business.

  • Re-evaluate business plans with an eye toward requirements of becoming a QSB entity.

  • Beware of post-financing transactions that might jeopardize QSB status later down the road.

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