Tax Credits May Make the End of 2011 an Attractive Time for Investing in Small Businesses

Many of you probably saw Kermit Nash’s post earlier this week regarding the status of the Minnesota Angel Tax Credit. In his post, Kermit notes that of the $15.9 million available for angel tax credits in 2012, the Minnesota Department of Employment and Economic Development has already allocated $9.02 million, leaving slightly less than $7 million available for allocations this year.

Apart from the good news that Minnesota companies have been able to take advantage of the tax credit and secure needed financing, the lesson, in part, is that if you want to take advantage of the tax credit this year, do not wait until the last minute, as it appears that this year’s tax credit may be fully allocated. If you want to know more, check out the hyperlinks in Kermit’s post.

Here’s another investor incentive that may help corporations raising capital this year. The Small Business Jobs Act of 2010 extended through the end of 2011 a tax break for certain investments in “qualified small businesses.” Assuming the investment satisfies all the requirements, up to 100% of the gain from the investment may be excluded from tax.

In order to qualify, the investment must be made before the end of this year in a “qualified small business”—a domestic C corporation (not an S corporation, LLC, or foreign corporation) that has not had more than $50 million in gross assets at any time since 1993 and will not exceed that threshold immediately after the issuance of the stock. In addition, at least 80% of the corporation’s assets must be used in a “qualified trade or business,” which term excludes certain types of businesses such as professional services, financial services, consulting, agriculture, extractive industries, and hospitality services. Technology companies, manufacturing companies, and retailers are some of the types of businesses that are considered “qualified” and have benefited from the exclusion.

Only non-corporate investors can take advantage of the tax break (corporations that invest in qualified small businesses are not eligible), and such an investor must: (i) purchase the stock directly from the qualified small business or indirectly from an underwriter, not from an existing shareholder, and (ii) pay for the stock using money or other property (not including stock), or be issued the stock as compensation for services. The investor must hold the stock for at least 5 years.

Assuming the investment meets these requirements, the investor should be able to exclude from income all or most of the gain on the qualified small business stock. There are, however, limits as to the amount of gain that can be excluded. The maximum amount of the exclusion in any one year is the greater of $10 million (reduced by the amount of eligible gain from stock in the same corporation from prior years), or 10 times the investor’s adjusted tax basis of the stock sold in that year.

If Congress doesn’t extend the current exclusion, it will expire at the end of this year, and investments in qualified small business stock will be eligible for a 50% tax exclusion, rather than the 100% exclusion available today.

Note that the 100% exclusion was initially set to expire at the end of 2010 until Congress extended it through 2011, so it is possible that the 100% exclusion may once again get extended into next year, or that it may get extended but at a reduced level. It is not at all clear what, if anything, Congress intends to do with the 100% exclusion, so any investor seeking to take advantage of the exclusion should complete a qualified investment this year.

There are, of course, exceptions to these rules, and any investor seeking to take advantage of the qualified small business stock tax exclusion should consult with their legal and tax advisor prior to making an investment.