Eliminate Capital Gains Taxes on Investments in Small Business Stock

The Omnibus Reconciliation Act of 1993 allowed taxpayers to exclude a portion of the capital gain on qualified small business stock from tax if the stock is held for at least five years by a non-corporate taxpayer. In general, 50 percent of the gain is excluded (60 percent for businesses in empowerment zones); the remaining gain is taxed at a maximum rate of 28 percent. The 2009 stimulus bill (the American Recovery and Reinvestment Act) temporarily raised the exclusion to 75 percent for stock issued between February 17, 2009 and January 1, 2011. The maximum gain eligible for the exclusion is limited to 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).

A portion 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 currently 7 percent of the excluded gain, but is scheduled to increase after 2010 to 28 percent of the excluded gain on stock acquired since 2001 and to 42 percent on stock acquired before 2001.

To qualify as a small business, the corporation may not have gross assets of $50 million or more at issuance 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 generally do not 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 maximum 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 to eliminate the AMT preference. The proposal would encourage more investment in some small businesses that qualify, but could also divert capital from more productive investments in firms that do not qualify for the benefit. By eliminating the second layer of tax, it would also encourage more qualifying firms to incorporate as C-corporations.

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