If you are considering buying a business, take note.  On January 1, 2011, many experts expect the long term capital gains rate to rise from 15% to 20% under the tax plan supported by President Obama. In addition, beginning in 2013, the tax rate on capital gains for high income individuals (adjusted gross income in excess of $200,000 or $250,000 for joint filers) is scheduled to rise an additional 3.8% as part of a provision enacted to pay for the new health care law. As a result, the federal tax on capital gains on business interests or other assets could be as high as 23.8% in 2013.  That's a 56% increase over today's rates.

However, a Wall Street Journal article entitled "For New Tax Breaks, Act Fast" (Sept. 30, 2010), explains that President Obama recently signed into law a new provision that creates an immediate opportunity for business buyers or investors to lock in a zero percent capital gains rate on long term investments in small business stock.

Qualifying small business investments are the stock of a regular corporation (not an S corporation) with less than $50 million in assets. The stock must have been purchased directly from the corporation and it must be held for at least 5 years.  The corporation must also be engaged in an active trade or business.

The amount of gain investors can exclude is limited to either the greater of ten times the investment or $10 million. Because the limitation is the greater of the two amounts, the amount excluded can exceed $10 million in some cases.

The rub is that buyers or investors only have until December 31, 2010 to take advantage of this new provision. However, those that do take advantage of it could benefit enormously.  Of course most business buyers will not be swayed to make an investment decision based solely on a tax incentive, but for those who have been considering a specific acquisition or transaction, this could sweeten the pot and provide an additional incentive to get the deal done by year end.

This new little known provision modifies the existing tax break for small business stock purchases in two ways. It allows selling shareholders to lock in a zero percent capital gains rate on 100% of the gain (not just the first 50%) on the sale of qualifying small business stock.

However, a range of businesses are not eligible for this capital gain exclusion.  These businesses include:
• Professional practices and service businesses that depend or rely on the skill or reputation of one or more individual
• Finance, banking, insurance, leasing, investing, and similar businesses
• Farms, mining and extraction industries
• Hotels, motels, restaurants, or similar businesses

Another attractive feature of the provision is that business buyers and investors are allowed to hold the stock of the acquired company in order to meet the 5 year holding requirement. In other words, business buyers who invest in a small company before year end are not forced to sell stock in the company and recognize their gains prematurely.

Another significant advantage of the newly enacted provision is that the gain is completely excluded from the AMT calculation. Under prior law, even though 50% of the gain in small business stock could be excluded, a part of the gain was added back in the AMT calculation.  This often resulted in a substantial loss of benefits for taxpayers subject to AMT.

This new provision provides very attractive tax relief for investors but the window to take advantage of the new law is only open until the end of 2010. The prospects for an extension of this window are uncertain. Therefore, buyers or investors in small businesses should do everything they can to ensure a transaction closes before year end so they can lock in the zero percent capital gains rate.

Please note that tax regulations and laws are complicated, MidCap does not provide tax advise so please discuss this potentially favorable provision with your tax and legal professionals.