About a decade ago, aiming to give a boost to developing small businesses, Congress granted an unusual tax break, allowing taxpayers who buy newly issued shares of qualified small business stock (QSBS) and hold it for five years to exclude from taxation half of their capital gain realized on the eventual sale.*

Sounds like a wonderful opportunity? Yes, but, as so often with tax legislation, it has its limitations.

Business limitations

First of all, not all small business stock qualified. The business issuing the stock had to be a domestic C corporation with no more than $50 million in assets at the time that the qualifying stock was issued. It had to have at least 80% of those assets in use in the active conduct of its business. And an extensive list of business types was excluded:

Businesses that performed services in health, law, engineering, architecture, accounting, performing arts, consulting, athletics, financial services or brokerage.

Businesses that have as their principal asset the reputation or skill of one or more employees.

Any banking, insurance, financing, leasing, investing or similar business.

Farming, mining or petroleum production.

Hotels, motels, restaurants and similar businesses.

Nonetheless, many small businesses do qualify.

Exclusion limitations

As one might expect, the exclusion itself has boundaries, albeit not overly burdensome ones. Capital gains eligible for the exclusion are limited to the greater of ten times the QSBS investor's cost basis or $10 million in gains from all transactions in the stock. There is also a generous provision for losses realized on the sale of small business stock. The owner can claim up to $50,000 of ordinary losses in the tax year of the sale — $100,000 on joint returns. (Any excess is treated as a capital loss, deductible against capital gains and up to $3,000 of ordinary income, with any excess carried forward to be deducted in succeeding years.)

Limitations on tax savings

In 1993 the tax rate on long-term capital gains was 28%. Thus, excluding half of your gain would result in an effective tax rate of 14%. However, 50% of your exclusion would then count as a tax preference for purposes of the alternative minimum tax (AMT). If you had to pay the 28% AMT on that amount, your effective tax would have risen to 21% — 28% on three-quarters of the total gain. Still a not inconsiderable break when gains are in the millions.

Then, before anyone had the opportunity to cash in on the deal, the Taxpayer Relief Act of 1997 altered the rules. Capital gains rates on stocks were capped at 20%, but the 28% rate was retained for QSBS. Because this could result in a higher effective rate on gains from the sale of QSBS than on ordinary long-term gains, an AMT adjustment was included. "Only" 42% of the excluded amount would now be a tax preference.

Therefore, half the gain would be subject to a 28% capital gains tax, and another 21% (42% of the excluded half) could be subject to a 28% AMT. That's a possible effective tax of 19.88% — a saving of a measly 0.12%, or $1,200 on a $1 million gain.

Still, for those whose income insulates them from the AMT, or those carrying forward an AMT credit from previous years, the QSBS option can make financial sense. Also, the 1997 Act did add one attractive feature . . .

A saving grace

Now QSBS is eligible for tax-free rollovers. The stock may be sold after being held six months or more, and the proceeds can be rolled over into the stock of another qualified small business with no tax consequences. The new purchase must be completed within 60 days of the sale. The five-year holding period would then run from the date that the original QSBS was received.

In any case, it's not really necessary to hold QSBS for five years. If, after a year or more, the investor feels that the stock has peaked, he or she can always sell and pay no more than 20% on the gain, with no AMT consequences.

Does a QSBS investment make sense for you? That's a question best answered in consultation with trusted and experienced professional advisers.

* A 60% exclusion may be available for stock issued after December 21, 2000, by a "qualified business entity" established within an empowerment zone.