Eliminate capital gains taxes on investments in small business stock

Under current law, 75 percent of capital gain on qualifying small business stock issued in 2009 (after February 17, 2009) and in 2010 is excluded from tax if the stock is held for at least five years. The other 25 percent of the gain is taxed at a maximum rate of 28 percent. The stimulus bill (the American Recovery and Reinvestment Act of 2009) temporarily raised the exclusion from 50 percent. After 2010, the exclusion is scheduled to return to 50 percent, and 60 percent for businesses in empowerment zones. The maximum gain eligible for the exclusion is the greater of $10 million ($5 million for married taxpayers filing separately) less any gain reported on prior tax returns, or 10 times the taxpayer’s cost basis (purchase price plus fees). Seven percent of the excluded gain is an AMT preference item (added to the AMT measure of income and subject to the alternative tax) The AMT preference is scheduled to increase after 2010 to 28 percent of the excluded gain on stock acquired in 2001 and to 42 percent on stock acquired on or before December 31, 2000.

To qualify as a small business, the corporation may not have gross assets of $50 million or more and may not be an S corporation.  The business must also meet certain active trade or business requirements.  As a result, small businesses in the service sector, hospitality, farming, finance, insurance, and mineral extraction do not generally qualify for special treatment.

The result of all these complicated rules is that new stock issued by certain small businesses is generally taxed at one-quarter of the taxpayer's marginal rate (up to a maximum of 28 percent) as long as it is held for at least five years. Thus, the maximum rate for qualifying small business stock is 7 percent. After 2010, the exclusion returns to 50 percent, and the effective capital gains tax rate on qualifying small business stock will double to 14 percent (11.2 percent in empowerment zones).

The president proposes to fully exempt capital gains on qualifying small business stock thus reducing the effective tax rate to zero - and allow the full exclusion on the AMT. The proposal would encourage more investment in some qualifying small businesses, but based on past experience its effect would be limited.  It also might divert some capital from more productive investments in firms that do not qualify for the benefit. The current 50 percent capital gains reduces revenues by only about $500 million per year, indicating that few taxpayers take advantage of the current exclusion. The proposal would be effective for qualified small business stock issued after February 17, 2009.

Additional Resources
Tax Policy Briefing Book: Capital Gains and Dividends: How are capital gains taxed?
The Complexity of Capital Gain Taxation, TaxVox, February 24, 2009
Description of Revenue Provisions Contained in the President’s Fiscal Year 2010 Budget Proposal; Part Two: Business Tax Provisions (JCS-3-09), Joint Committee on Taxation, September 2009, pp 5-6