Impact of the Taxpayer Relief Act of 1997 on Qualified Small Business Stock

Background
On August 5, 1997, the President signed the Taxpayer Relief Act of 1997 (the Act) into law. The Act is notable for providing taxpayers with the biggest tax cut in more than 16 years and for its breadth and complexity. As you may know, the Act contains some important relief for U.S. and foreign investors, such as significantly reduced -- and more complex -- capital gains rates, and of particular interest to our clients, the new pro***visions affecting investments in qualified small business stock. We would like to take this opportunity to provide you with an overview of the Act's impact upon such investments. As always, we invite you to contact us for more information regarding the new tax law or any other tax issues you may have.

Overview of the Tax Treatment of Qualified Small Business Stock

Generally speaking, section 1202 of the Internal Revenue Code of 1986 (the Code), as amended, permits noncorporate taxpayers to exclude 50% of any gain from the sale of qualified small business stock (QSBS) held for more than 5 years, subject to certain limits on the amount excludable. In order for stock to be eligible for QSBS treatment, the stock, its acquisition by the taxpayer and the issuing corporation must meet certain requirements. For more information on these requirements, please consult our March 1994 Cooley Alert. Please contact us to obtain a copy of that memorandum.

Since one half of the gain recognized on a sale or exchange of QSBS is generally excluded from taxable income, the effective tax rate on such gain from QSBS held for more than 5 years is reduced from a maximum of 28% to a maximum of 14%. Despite the numerous changes and reductions in capital gains rates caused by the Act, the 14% effective tax rate for gain from QSBS related investments remains the same.

The New Rollover Law

Nevertheless, the Act does provide one QSBS related tax benefit -- the rollover of gain provision found in new Code Section 1045. If the provisions of this new section of the Code are satisfied, QSBS held for less than five years can be sold without the seller incurring any tax liability if the proceeds are reinvested in new QSBS.

New Code Section 1045 provides that an "individual" (see discussion below) may elect to roll over the gain from the sale of QSBS held for more than 6 months (Old QSBS) if other QSBS is purchased by the individual within the rollover period (Replacement QSBS). The rollover period is the 60-day period beginning on the date of sale of the Old QSBS. This new rollover provision is effective for sales of Old QSBS by individuals which occur after August 5, 1997.

Accordingly, if a taxpayer qualifies and elects for the rollover provision to apply:

As mentioned above, this new rollover provision is limited to individuals. Until the adoption of the Tax Technical Corrections Act of 1997, it was uncertain whether rollovers into partnerships or other entities that invest in QSBS would be entitled to relief under Section 1045. The Tax Technical Corrections Act of 1997 clarifies (and limits) Section 1045 by adding a provision which states that the rollover provision is available for S corporations and partnerships, but "only if at all times during such taxable year all of the partners of the partnership, or all of the shareholders of the S corporation, are natural persons or estates." Reinvestment of Old QSBS proceeds into most venture capital partnerships would therefore not qualify for deferral under Section 1045. Side-by-side venture capital partnerships may become more attractive now with one partnership being limited to individuals and the other partnership being owned by entities.

Accordingly, individuals holding Old QSBS (including Old QSBS received in distributions from investment partnerships) can avail themselves of the rollover provisions of Section 1045 by reinvesting the proceeds from their sales of Old QSBS either directly into new QSBS within 60 days or indirectly into eligible partnerships or S corporations, provided the partnership or S corporation invests the individual's capital contribution in new QSBS within 60 days after the individual's sale of Old QSBS. Please note that the new rollover provision does not otherwise affect the ability of individuals in venture capital partnerships to benefit from the general QSBS provisions with respect to QSBS investments of such partnerships.

Despite the aforementioned limitation, this new provision is quite a boon to QSBS holders. It effectively gives such holders the ability to dispose of old QSBS investments and to reinvest in more attractive QSBS investments without recognizing gain and yet preserving QSBS benefits on the new investments.

Example: Mr. Bill, an individual, owns 100 shares of stock in ABC Corporation, a qualified small business, which he purchased for $100. After holding such stock for 10 months, Mr. Bill sells the QSBS to Mr. Ed for $1,000. If Mr. Bill purchases XYZ Corporation stock as replacement QSBS for $1,000 within the 60-day period following his sale, he will not recognize any gain in the transaction, his tax basis in his ABC Corporation stock ($100) will carry over to the XYZ Corporation stock and the period he held the ABC Corporation Stock (10 months) will be tacked to the holding period of the XYZ Corporation stock for purposes of meeting the 5-year holding period requirement for QSBS treatment under Section 1202.