There are sections in the tax code relating to qualified small business stock that might be of assistance in minimizing the tax bite on certain investments in small-cap companies. This is a very technical area of tax law, and this page is designed only to familiarize individuals with some of the general parameters relating to investments in qualified small business stock. Investors are advised to consult their tax advisors for more information.

The information below is reprinted from IRS Publication 550, entitled Investment Income and Expenses, for use in preparing 2004 returns.

Gains on Qualified Small Business Stock

This section discusses two provisions of the law that may apply to gain from the sale or trade of qualified small business stock. You may qualify for a tax-free rollover of all or part of the gain. You may be able to exclude part of the gain from your income.

Qualified small business stock- This is stock that meets all of the following tests:

1. It must be stock in a C corporation.
2. It must have been originally issued after August 10, 1993.
3. The corporation must have total gross assets of $50 million or less at all times after August 9, 1993, and before it issued the stock. Its total gross assets immediately after it issued the stock must also be $50 million or less.
4. When figuring the corporation's total gross assets, you must also count the assets of any predecessor of the corporation. In addition, you must treat all corporations that are members of the same parent-subsidiary controlled group as one corporation. You must have acquired the stock at its original issue, directly or through an underwriter, in exchange for money or other property (not including stock), or as pay for services provided to the corporation (other than services performed as an underwriter of the stock). In certain cases, your stock may also meet this test if you acquired it from another person who met this test, or through a conversion or trade of qualified small business stock that you held.
5. The corporation must have met the active business test, defined later, and must have been a C corporation during substantially all the time you held the stock.
6. Within the period beginning 2 years before and ending 2 years after the stock was issued, the corporation cannot have bought more than a de minimis amount of its stock from you or a related party.
7. Within the period beginning 1 year before and ending 1 year after the stock was issued, the corporation cannot have bought more than a de minimis amount of its stock from anyone, unless the total value of the stock it bought is 5% or less of the total value of all of its stock.

For more information about tests 6 and 7, see the regulations under section 1202 of the Internal Revenue Code.

Active business test- A corporation meets this test for any period of time if, during that period, both of the following are true.

1. It was an eligible corporation, defined below.
2. It used at least 80% (by value) of its assets in the active conduct of at least one qualified trade or business, defined below.

Exception for SSBIC-Any specialized small business investment company (SSBIC) is treated as meeting the active business test. An SSBIC is an eligible corporation that is licensed to operate under section 301(d) of the Small Business Investment Act of 1958 as in effect on May 13, 1993.

Eligible corporation-This is any U.S. corporation other than:

1. A Domestic International Sales Corporation (DISC) or a former DISC,
2. A corporation that has made, or whose subsidiary has made, an election under section 936 of the Internal Revenue Code, concerning Puerto Rico and possession tax credit,
3. A regulated investment company,
4. A real estate investment trust (REIT),
5. A real estate mortgage investment conduit (REMIC),
6. A financial asset securitization investment trust (FASIT), or
7. A cooperative.

Qualified trade or business-This is any trade or business other than:

1. One involving services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services,
2. One whose principal asset is the reputation or skill of one or more employees,
3. Any banking, insurance, financing, leasing, investing or similar business,
4. Any farming business (including the business of raising or harvesting trees),
5. Any business involving the production or extraction of products for which percentage depletion can be claimed, or
6. Any business of operating a hotel, motel, restaurant, or similar business.

Rollover of Gain

You may qualify for a tax-free rollover of capital gain from the sale of qualified small business stock held more than 6 months. This means that, if you buy certain replacement stock and make the choice described in this section, you postpone part or all of your gain.

You postpone the gain by adjusting the basis of the replacement stock as described in Basis of replacement stock, below. This postpones your gain until the year you dispose of the replacement stock

You can make this choice if you meet all the following tests.

1. You buy replacement stock during the 60-day period beginning on the date of the sale.
2. The replacement stock is qualified small business stock.
3. The replacement stock continues to meet the active business requirement for small business stock for at least the first 6 months after you buy it.

Amount of gain recognized-If you make the choice described in this section, you must recognize the capital gain only up to the following amount:

1. The amount realized on the sale, minus
2. The cost of any qualified small business stock you bought during the 60-day period beginning on the date of sale (and did not previously take into account on an earlier sale of qualified small business stock).

If this amount is less than the amount of your capital gain, you can postpone the rest of that gain. If this amount equals or is more than the amount of your capital gain, you must recognize the full amount of your gain.

Basis of replacement stock-You must subtract the amount of postponed gain from the basis of your replacement stock.

Holding period of replacement stock-Your holding period for the replacement stock includes your holding period for the stock sold, except for the purpose of applying the 6-month holding period requirement for choosing to roll over the gain on its sale.

Pass-through entity-A pass-through entity (a partnership, S corporation, or mutual fund or other regulated investment company) also may make the choice to postpone gain. The benefit of the postponed gain applies to your share of the entity's postponed gain if you held an interest in the entity for the entire period the entity held the stock.

If a pass-through entity sold qualified small business stock held for more than 6 months and you held an interest in the entity for the entire period the entity held the stock, you also may choose to postpone gain if you, rather than the pass-through entity, buy the replacement stock within the 60-day period.

How to report gain-Report the entire gain realized from the sale on line 1 or line 8 of Schedule D (Form 1040), whichever is appropriate. To make the choice to postpone the gain, enter "Section 1045 Rollover" in column (a) of the line directly below the line on which you reported the gain. Enter the amount of gain postponed in column (f). Enter it as a loss (in parentheses).

You must make the choice to postpone gain no later than the due date (including extensions) for filing your tax return for the year in which you sold the stock. If your original return was filed on time, you may make the choice on an amended return filed no later than 6 months after the due date of your return (excluding extensions). Enter "Filed pursuant to section 301.9100-2" at the top of the amended return, and file it at the same address you used for your original return.

Section 1202 Exclusion

You generally can exclude from your income one-half of your gain from the sale or trade of qualified small business stock held by you for more than 5 years. The taxable part of your gain equal to your section 1202 exclusion is a 28% rate gain. See Capital Gain Tax Rates, later.

SSBIC stock-If the stock is specialized small business investment company (SSBIC) stock that you bought as replacement property for publicly traded securities you sold at a gain, you must reduce the basis of the stock by the amount of any postponed gain on that earlier sale, as explained earlier under Rollover of Gain From Publicly Traded Securities. But do not reduce your basis by that amount when figuring your section 1202 exclusion.

Limit on eligible gain-The amount of your gain from the stock of any one issuer that is eligible for the exclusion in 2004 is limited to the greater of :

1. Ten times your basis in all qualified stock of the issuer that you sold or exchanged during the year, or
2. $10 million ($5 million for married individuals filing separately) minus the amount of gain from the stock of the same issuer that you used to figure your exclusion in earlier years.

How to report gain-Report the entire gain realized from the sale in column (f) of line 8 of Schedule D (Form 1040). Report an amount equal to the excluded gain in column (g). Directly below the line on which you report the gain, enter "Section 1202 exclusion" in column (a) and enter the amount of the exclusion in column (f). Enter it as a loss (in parentheses).

More information-For information about additional requirements that may apply, see section 1202 of the Internal Revenue Code.

The Research Works, LLC

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