Improved tax break for small firms

Nation's Business, Feb, 1998 by Joan Pryde

A little-known break on the capital-gains tax on sales of small-business stock is getting more notice since Congress improved it in the Taxpayer Relief Act enacted Aug. 5. Tax experts say the added attention to the break is important for business owners who might otherwise overlook a good tax-saving opportunity.

Until recently, the tax break was "a real unsung hero. I don't think many people [were] aware of it at all," says Tom Ochsenschlager, a partner in the Washington, D.C., office of accounting firm Grant Thornton LLP.

The original provision, as enacted Aug. 10, 1993, entitles individuals to what is in effect a 14 percent capital-gains rate on the sale of certain small-business stock if the stock was purchased after that date and was held at least five years. The 14 percent rate is 6 percentage points below the new long-term rate of 20 percent, which applies to capital gains on stock held longer than 18 months.

A stock qualifies for the special capital-gains treatment only if it is from a C corporation that is engaged in an active business and has gross assets of no more than $50 million. Some service-related professions are excluded, however; among them are health care, law, engineering, accounting, and financial services.

The intent of the tax break was to get more outside capital flowing into small companies, tax experts say, but investors balked at having to hold the same stock for five years to get the lower capital-gains rate.

That concern was addressed by the 1997 Taxpayer Relief Act. It includes a "rollover" provision that requires only that a stock purchaser keep his or her money invested in any qualified small-business stocks for five years to be eligible for the 14 percent capital-gains rate. Under this provision, a stock can be sold within the five-year window as long as the principal and any gain are reinvested in another qualified small-business stock.

Ochsenschlager notes that small-business owners who started companies after Aug. 10, 1993, and who have invested heavily in their firms are eligible for the tax break on the stock they hold. This point is especially important for planning purposes with the approach of the first five-year mark -- Aug. 10, 1998.

"If you sell your business before five years is up, you're in effect paying more tax than you have to," Ochsenschlager says. "It's critical that if someone made an investment after [the law was enacted], they try to be careful about watching for the five-year window."

The 1993 law specifies that a taxpayer achieves the 14 percent rate by excluding 50 percent of the capital gain and paying a rate of 28 percent on the rest.